Recent Occasional Papers of the International Monetary Fund

42. Global Effects of Fund-Supported Adjustment Programs, by Morris Goldstein. 1986. 43. International Capital Markets: Developments and Prospects, by Maxwell Watson, David Mathieson, Russell Kincaid, and Eliot Kalter. 1986 44. A Review of the Fiscal Impulse Measure, by Peter S. Heller, Richard D. Haas, and Ahsan H. Mansur. 1986. 45. Switzerland's Role as an International Financial Center, by Benedicte Vibe Christensen. 1986. 46. Fund-Supported Programs, Fiscal Policy, and Income Distribution: A Study by the Fiscal Affairs Department of the International Monetary Fund. 1986. 47. Aging and Social Expenditure in the Major Industrial Countries, 1980-2025, by Peter S. Heller, Richard Hemming, Peter W. Kohnert, and a Staff Team from the Fiscal Affairs Department. 1986. 48. The European Monetary System: Recent Developments, by Horst Ungerer, Owen Evans, Thomas Mayer, and Philip Young. 1986. 49. Islamic Banking, by Zubair Iqbal and Abbas Mirakhor. 1987. 50. Strengthening the International Monetary System: Exchange Rates, Surveillance, and Objective Indicators, by Andrew Crockett and Morris Goldstein. 1987. 51. The Role of the SDR in the International Monetary System, by the Research and Treasurer's Departments of the International Monetary Fund. 1987. 52. Structural Reform, Stabilization, and Growth in Turkey, by George Kopits. 1987. 53. Floating Exchange Rates in Developing Countries: Experience with Auction and Interbank Markets, by Peter J. Quirk, Benedicte Vibe Christensen, Kyung-Mo Huh, and Toshihiko Sasaki. 1987. 54. Protection and Liberalization: A Review of Analytical Issues, by W. Max Corden. 1987. 55. Theoretical Aspects of the Design of Fund-Supported Adjustment Programs: A Study by the Research Department of the International Monetary Fund. 1987. 56. Privatization and Public Enterprises, by Richard Hemming and Ali M. Mansoor. 1988. 57. The Search for Efficiency in the Adjustment Process: Spain in the 1980s, by Augusto Lopez-Claros. 1988. 58. The Implications of Fund-Supported Adjustment Programs for Poverty: Experiences in Selected Countries, by Peter S. Heller, A. Lans Bovenberg, Thanos Catsambas, Ke-Young Chu, and Parthasarathi Shome. 1988. 59. The Measurement of Fiscal Impact: Methodological Issues, edited by Mario I. Blejer and Ke-Young Chu. 1988. 60. Policies for Developing Forward Foreign Exchange Markets, by Peter J. Quirk, Graham Hacche, Viktor Schoofs, and Lothar Weniger. 1988. 61. Policy Coordination in the European Monetary System. Part I: The European Monetary System: A Balance Between Rules and Discretion, by Manuel Guitian. Part II: Monetary Coordination Within the European Monetary System: Is There a Rule? by Massimo Russo and Giuseppe Tullio. 1988. 62. The Common Agricultural Policy of the European Community: Principles and Consequences, by Julius Rosenblatt, Thomas Mayer, Kasper Bartholdy, Dimitrios Demekas, Sanjeev Gupta, and Leslie Lipschitz. 1988. 63. Issues and Developments in International Trade Policy, by Margaret Kelly, Naheed Kirmani, Miranda Xafa, Clemens Boonekamp, and Peter Winglee. 1988. 64. The Federal Republic of Germany: Adjustment in a Surplus Country, by Leslie Lipschitz, Jeroen Kremers, Thomas Mayer, and Donogh McDonald. 1989. 65. Managing Financial Risks in Indebted Developing Countries, by Donald J. Mathieson, David Folkerts-Landau, Timothy Lane, and Iqbal Zaidi. 1989.

Note: For information on the titles and availability of Occasional Papers published prior to 1986, please consult the most recent IMF Publications Catalog or contact IMF Publication Services.

©International Monetary Fund. Not for Redistribution Occasional Paper No. 65

Managing Financial Risks in Indebted Developing Countries

By Donald J. Mathieson, David Folkerts-Landau, Timothy Lane, and Iqbal Zaidi

International Monetary Fund Washington, D.C. June 1989

©International Monetary Fund. Not for Redistribution © 1989 International Monetary Fund

Library of Congress Cataloging-in-Publication Data

Managing financial risks in indebted developing countries / by Donald J. Mathieson. . .[et al.]. p. cm. — (Occasional paper / International Monetary Fund ; no. 65) "June 1989." Bibliography: p. ISBN 1-55775-116-1 1. Financial futures—Developing countries. 2. Foreign exchange fu- tures—Developing countries. 3. Hedging (Finance)—Developing countries. 4. Risk management—Developing countries. I. Mathieson, Donald J. II. Series: Occasional paper (International Monetary Fund) ; no. 65. HC6024.9.D44M36 1989 332.63'2'091724—dc20 89-11125 CIP

Price: US$10.00 (US$7.50 university faculty members and students)

Address orders to: External Relations Department, Publication Services International Monetary Fund, Washington, D.C. 20431

©International Monetary Fund. Not for Redistribution Contents

Page Preface v

I. Introduction 46

II. Financial and Commodity Price Risks Confronting Indebted 46 46 Deveoing Countres Interest Rate Variability Exchange Rate Variability Commodity Price Variability Adjustment Policies and Financial and Commodity Price Risks Responses to External Risks

III. Market-Based Interest Rate Hedging 46 Development of Market-Based Hedging Instruments Use of Market-Based Interest Rate Hedging Instruments by Indebted Developing Countries Short-Term Hedging Operations Using the Eurodollar Futures Contract Characteristics of Eurodollar Futures Contract Design of a Short-Term Eurodollar Interest Rate Hedge Medium-Term Hedging Operation Using Interest Rate Caps Some Factors Limiting Use of Interest Rate Hedging by Indebted Developing Countries Market-Based Hedging Strategies and Adjustment Programs

IV. Summary 19

Appendices I. Futures and Forward Markets 20 II. Options Markets 28 III. Commodity Hedging: Examples 32 IV. Glossary 39 Bibliography 46

TABLES Section

III. 1. Trading Volume and Open Interest in Eurodollar Futures and

Futures Options Contracts, 1981-87 10

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©International Monetary Fund. Not for Redistribution CONTENTS

Page

2. Eurodollar Futures Contract Specification 12 3. Margin Requirements 13 4. Illustration of Eurodollar Futures Hedge 14 5. Premiums for Interest Rate Caps on Three-Month LIBOR as of July 1988 16 6. Illustration of Interest Rate Cap Hedge 16

Appendix

I. Al. Some Commodity Futures Markets Relevant to Developing Countries 20 A2. An Example of Specifications for a Futures Contract 21 A3. Some Commodity Futures Markets: Recent Size 21 A4. Some Foreign Exchange Futures Markets 22 A5. Some Interest Rate Futures Contracts 22 A6. Example of a Financial Futures Contract 23 A7. Some Examples of Futures Prices 27

II. A8. Some Commodity Futures Options Markets 28 A9. Some Foreign Exchange Options and Futures Options 29 A10. Some Interest Rate Options 29 Al1. Some Examples of Futures Option Premiums 31

III. A12. Sugar Producer's Revenues 32 A13. Effects of Sugar Futures Hedge 33 A14. Effects of Sugar Future Options Hedge 33 A15. Revenues Associated with Output Uncertainty 35 A16. Effects of Sugar Futures or Options Hedges with Output Uncertainty 36 A17. Effects of Wheat Futures or Options Hedges 37

CHARTS Section

II. 1. Nominal and Real International Interest Rates, 1965-88 2 2. Indices of Exchange Rate Volatility, 1960-88 4 3. Indices of Commodity Price Volatility, 1960-88 5

The following symbols have been used throughout this paper:

... to indicate that data are not available; — to indicate that the figure is zero or less than half the final digit shown, or that the item does not exist; - between years or months (e.g., 1984—85 or January-June) to indicate the years or months covered, including the beginning and ending years or months; / between years (e.g., 1985/86) to indicate a crop or fiscal (financial) year. "Billion" means a thousand million. Minor discrepancies between constituent figures and totals are due to rounding.

iv

©International Monetary Fund. Not for Redistribution Preface

This study was prepared in the Financial Studies Division of the Research Department of the International Monetary Fund. Its authors are Donald J. Mathieson, Division Chief; David Folkerts-Landau, Assistant Division Chief; and Timothy Lane and Iqbal Zaidi, Economists. The authors are especially indebted to Morris Goldstein, Deputy Director of the Research Department, for his support in the preparation of the study and many helpful substantive comments and editorial suggestions. A number of colleagues, both in the Fund and the World Bank, greatly facilitated the preparation of this study by their willingness to exchange views and provide information. The authors are also grateful to Kellett Hannah and Rosita Vera-Bunge for their excellent research assistance, to the editor, Elin Knotter, of the External Relations Department, and to Gail Campbell and Rosalind Oliver, for their excellent typing services. The authors alone are responsible for the study; the opinions expressed are theirs and do not necessarily reflect the views of the Fund. The information for this report was obtained in part through discussions with market participants and the regulatory authorities in the major markets for hedging instruments in France, Japan, the United Kingdom, and the United States during recent inter- national capital markets missions,* as well as during a special visit to New York to discuss the pricing of interest rate caps and other hedging instruments with major commercial banks and securities houses. The staff of the Financial Operations De- partment in the World Bank were extremely helpful in providing information on their program to develop the infrastructure for hedging programs in a variety of developing countries. The Chilean authorities also graciously provided information on the nature of their hedging activities in the Eurodollar financial futures markets. It should be noted that the term "country" used in this study does not in all cases refer to a territorial entity that is a state as understood by international law and practice. The term also covers some territorial entities that are not states but for which statistical data are maintained and provided internationally on a separate and inde- pendent basis.

* The most recent report is International Capital Markets: Developments and Prospects, by a Staff Team from the Exchange and Trade Relations and Research Departments (Washington: International Monetary Fund, April 1989).

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©International Monetary Fund. Not for Redistribution This page intentionally left blank

©International Monetary Fund. Not for Redistribution I Introduction

A notable characteristic of the 1970s and 1980s has ing instruments that could potentially be useful to in- been the high variability of international interest rates, debted developing countries as they seek to manage the primary commodity prices, and major currency exchange financial risks created by variability of the prices of ex- rates. Quite apart from the effects on industrial countries, ternal assets and commodities. Section II reviews the such international price variability presents a particular variability in interest rates, in exchange rates, and in problem for indebted developing countries because it is prices of primary commodities and then analyzes the essentially "beyond their control." This is not the same, effects of this variability on the domestic and external however, as saying that measures cannot be taken to performance of indebted developing countries. Section reduce the impact of such variability. Indeed, the un- III examines those market-related hedging instruments certainties created by price and interest rate variability that are accessible to indebted developing countries. The have spawned new official and private sector arrange- discussion covers the characteristics of the hedging in- ments for dealing with the associated risks. In the Fund, struments, the cost of hedging operations, the depth of for example, the creation of the compensatory and con- the markets for these instruments, and the design of hedg- tingency financing facility (CCFF) reflected the desire to ing strategies. Some of the issues that would have to be help maintain the momentum of adjustment in programs addressed in determining if and how these hedging in- in the face of adverse external shocks. Meanwhile, the struments could play a role in adjustment programs and use of market-related hedging instruments has expanded in debt reschedulings are also discussed. Finally, Section strongly, encompassing both the growth of traditional IV presents a summary of key issues and several topics futures and options markets and the introduction of new for discussion. Four appendices provide more detailed instruments (for example, futures contracts on Eurodollar information on the characteristics of hedging instruments, interest rates). including an extensive glossary that explains in detail This paper examines the types of market-related hedg- most of the technical terms used in the paper.

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©International Monetary Fund. Not for Redistribution II Financial and Commodity Price Risks Confronting Indebted Developing Countries

Throughout most of the 1970s and 1980s, fluctuations Since a large portion of the international borrowing un- in world prices of primary commodities, in international dertaken by developing countries has been denominated interest rates, and in exchange rates of major currencies in the U.S. dollar and carries an interest rate indexed to affected the economies of the indebted developing coun- the LIBOR, fluctuations in nominal and real LIBOR in- tries through various channels. Since the external bank terest rates provide a relevant measure of interest rate debt of developing countries has typically carried an in- variability (Chart 1). The degree of interest rate volatility terest rate tied to the London interbank offer rate is represented in Chart 1 by the standard deviation of the (LIBOR), interest rate variability has at times made pro- monthly interest rates observed over the preceding two spective debt-service payments highly uncertain. In ex- change rate movements among the currencies of the major Chart 1. Nominal and Real International Interest industrial countries, there were induced effects on de- Rates, 1965-88 veloping countries' terms of trade, the value of their (In percent per annum) reserves, and on debt-service payments (the currency 30 composition of net foreign liabilities has been less di- versified than developing countries' export receipts). Fi- 20 nally, variability in commodity prices has generated in some cases sharp fluctuations in export receipts and in 10 the cost of imports. This variability in the prices of goods and assets has 0 not only made the formulation and implementation of -10 adjustment programs more difficult but may also have discouraged some countries from opening up their econ- -20 omies more to international trade and capital flows. When real interest rates are highly variable, the scale of fi- -30 nancing that should accompany an adjustment program, 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 for example, becomes highly uncertain. Moreover, while 18 greater participation in international trade and finance 15 generally yields efficiency gains by allowing countries to focus production in the areas of their greatest com- 12 parative advantage, highly variable prices for traded goods and highly variable interest rates can also make the nature 9 and sustainability of these gains uncertain. In what follows, a more precise picture is presented 6 of the extent of variability in interest rates, in primary commodity prices, and in exchange rates. As will become 3 apparent, a tendency has emerged for this variability to 0 extend across all major asset and commodity markets. 65 66 67 68 69 70 71 72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88

1 The nominal interest rate is measured as the London interbank offer rate (LIBOR) on six-month U.S. dollar deposits (period averages in Interest Rate Variability percent per annum). The real interest rate is the nominal interest rate minus the annual percentage change in non-oil developing countries' export unit values in dollars. Changes in both nominal and real international interest 2 Interest rate volatility is measured as the standard deviation of the rates have been historically large in the post-1972 period. levels in the preceding 24-month period of nominal and real LIBOR.

2

©International Monetary Fund. Not for Redistribution Exchange Rate Variability years.1 Real interest rates are approximated by adjusting such borrowing is based on a formula that ties the costs the LIBOR interest rate by the percentage change in an of funds to a market interest rate—(generally represented index of developing countries' export prices over the by the LIBOR or the U.S. prime interest rate)—plus a preceding year.2 By any of these measures, fluctuations margin or spread. These spreads over LIBOR vary ac- in international interest rates have at times been "large" cording to the perceived risks associated with lending to during the 1970s and 1980s. Note also that there have a particular country and with the degree of liquidity in been alternating intervals of tranquillity and turbulence international capital markets. Since a developing country in interest rates during the period. is more likely to experience debt-service difficulties when This volatility of international interest rates has had an interest rates are high and/or variable, spreads often rise increasingly important effect on the current account po- during such periods.5 sitions of developing countries. Prior to the mid-1970s, Developing countries have effectively taken on a rel- interest rate variability had a relatively limited impact on atively "open" (unhedged) position regarding interest the debt-service payments of developing countries both rate variability.6 As a result, a rise in real international because conditions in the international credit markets were interest rates can have a significant effect on the interest relatively stable and because a large proportion of out- payments ratio—defined as interest payments divided by standing debt—particularly for the low-income coun- exports of goods and services. Furthermore, the size of tries—had been contracted from official sources at fixed this effect varies considerably across different subgroups rates and on concessionary terms. By the late 1970s, this of developing countries, reflecting considerable differ- picture had changed sharply. Developing countries be- ences in the ratio of external debt to exports of goods came much more dependent on private external financing and services, the share of external debt owed to private as both the public sector and private residents borrowed creditors, and the proportion of external debt with vari- heavily in world capital markets. There was a marked able interest rates. For the capital importing developing shift from nondebt-creating flows (official transfers and countries as a group, it is estimated that a 1 percentage private direct investment) to debt-creating and interest- point rise in interest rates would directly increase the sensitive borrowing in world capital markets. The con- interest payments ratio by about 1 percentage point. The tribution of bank borrowing to the financing required for middle-income countries are especially affected because the current account deficit of the capital importing de- they have borrowed proportionately more from private veloping countries rose from 54 percent in 1970 to 74 sources. percent in 1981. As a result, the share of total external debt that was subject to floating interest rates increased from one fourth in 1973 to more than half in 1985.3 Exchange Rate Variability This rapid growth in external indebtedness, and the changes in the composition of that debt, greatly increased Periods of increased variability in international interest the sensitivity of developing countries to events in world rates have typically been associated with greater vari- financial markets. Countries with large floating rate ob- ability in key currency exchange rates. Although some ligations faced complicated debt management problems, observers had anticipated in the early 1970s that short- arising not only from the increase in the real cost of such term movements in key currency exchange rates would obligations during 1979-82 but also from the high vol- decline once the transition to more flexible exchange rate atility of interest rates and the reduction in average ma- arrangements was completed, exchange rate variability turities and grace periods.4 The cost of international bank has remained quite high. Indeed, the period since 1979 lending for developing countries is particularly vulnerable has featured some of the largest changes in exchange to interest rate variability because the interest rate on rates for major currencies since the early 1970s. Measures of the volatility in nominal and real effective exchange rates of the U.S. dollar vis-a-vis other major currencies are presented in Chart 2. In brief, the chart 1 The assumption embodied in the use of this index of unpredictability suggests that since the move to generalized floating in is that the interest rate expected in any month of the period is the average rate for the whole period. Two versions of interest rate fluc- tuations were initially calculated: one used data for the 24-month period preceding the quarter for which a measure is reported, and the other used data for the 12-month period. Since both versions give virtually 5 These spreads can also be affected by a loss of confidence caused the same results, only the 24-month period calculations are reported. by increased perception of risks concerning commercial bank lending 2 Naturally, other price series can be used to calculate real interest and by the competition by banks for funds when public sector imbal- rates. While these will yield different estimates of variability for real ances increase. interest rates, they generally show greater variability for real than for 6 This position could be implicitly hedged if these countries held nominal interest rates. assets (for example, foreign exchange reserves) denominated in the 3 By engaging in floating interest rate lending, bank creditors essen- same currencies and with similar maturities to their external liabilities. tially transformed their own interest rate risks into credit risks. In most cases, however, the external assets of these countries are 4 Maturities and grace periods on loans from private creditors are significantly smaller and may be of shorter maturity than their external typically shorter than those from official creditors. liabilities.

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©International Monetary Fund. Not for Redistribution II • FINANCIAL RISKS CONFRONTING INDEBTED DEVELOPING COUNTRIES

Chart 2. Indices of Exchange Rate Volatility, a more disaggregated level, since the relative importance 1960-881 of the major industrial countries in world markets varies substantially across commodities and manufactured goods. (In percent per annum) Given these linkages between movements in major currency exchange rates and terms of trade of developing 3.5 countries, exchange rate variability has the potential for creating considerable uncertainty regarding future export and import prices. In so doing, it necessarily makes trade 3.0 projections less precise and complicates longer-term de- cisions regarding the allocation of resources to different sectors.9

2.5 Commodity Price Variability

2.0 The increasing importance of manufactures in total exports of developing countries has partly mitigated the effects of unstable commodity export earnings. Also, there are important differences in the behavior and mag- 1.5 nitude of swings between terms of trade of developing countries and real commodity prices. Developing coun- tries are no longer uniformly exporters of primary com- 1.0 modities and importers of manufactures;10 in addition, their terms of trade (the ratio of export to import prices) are not merely a reflection of the behavior of the real price of commodities in terms of manufactures. Never- 0.5 theless, these two series do display similar trends, and the primary sector continues to play a major role in the determination of gross national product (GNP) and in the 0 generation of foreign exchange resources. 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 Prices of non-oil primary commodities have shown 1 Exchange rate volatility is measured as the standard deviation of large short-term fluctuations over the last two decades in the 24-month percentage change in the nominal and real effective response to shifts in both demand and supply factors. exchange rates of the U.S. dollar vis-a-vis the Japanese yen, the deutsche mark, the French franc, and the pound sterling. Also, most prices have undergone at least brief periods of very rapid increases that later have been substantially 1973, exchange rates have displayed large fluctuations, reversed, suggesting that commodity prices, like ex- and that these fluctuations have not declined in the 1980s.7 change rates, may have a tendency to "overshoot" in The response of the terms of trade to movements in response to unexpected developments. Because of large key currency exchange rates depends not only on the shifts in supply and demand for individual commodities, extent of exchange rate movements but also on initial commodity prices have not always moved together, and trade balances and on the types of goods exported and in many cases these movements have run counter to gen- imported. Recent analyses suggest that, other things being eral inflationary trends in the major industrial countries. equal, a 1 percentage point depreciation of the U.S. dollar Chart 3 provides a snapshot of commodity price vol- against the currencies of other industrial countries would atility in the period since the early 1960s. It shows an result in similar percentage increases in the dollar prices overall commodity price index, indices for various 8 of both nonfuel primary commodities and manufactures. subgroups of commodities, and a number of individual But the effect of a dollar depreciation on relative prices commodity prices.11 The aggregate index has moved of various traded goods could be considerably larger at sharply but, as one would expect, not as much as the

7 The volatility measure presented is the standard deviation of the 9 Exchange rate variability can also influence flows of investment monthly percentage change in the effective exchange rate calculated income depending on the nature of the currency composition of the for the 24-month period preceding the quarter for which data are country's foreign assets and liabilities. reported. 10 The proportion of exports of manufactures in total developing 8 This does not mean that expressing commodity prices in a currency country exports rose from 10 percent in 1973 to over 17 percent in other than the U.S. dollar would eliminate the effects of exchange rate 1985. variability on commodity prices. 11 The aggregate index has been available only since 1973.

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©International Monetary Fund. Not for Redistribution Responses to External Risks

Chart 3. Indices of Commodity Price Volatility, Adjustment Policies and Financial and 1960-881 Commodity Price Risks

(In percent per annum) Since fluctuations in prices of international assets and commodities can potentially have a strong impact on the 10 economic performance of indebted developing countries, periods of increased international price variability have 8 often created difficulties for the formulation and imple- mentation of adjustment policies.14 Recent experience 6 with Fund-supported adjustment programs suggests that this variability is more likely to have an impact on an 4 adjustment program as the time horizon of adjustment programs is extended to the medium term. In 125 of the 2 stand-by and extended arrangements that were approved in 1982-87, exogenous external developments deviated substantially from those assumed at the onset of the pro- 0 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 gram in 44 percent of the arrangements. In the other 56 20 percent, developments in individual external factors were at times quite large but mutually offsetting so that the overall effect on the program was limited. Deviations 15 from program assumptions occurred about evenly in ad- verse and favorable directions. As a broad order of mag- nitude, the average adverse deviation was 3 percent of 10 GDP and 100 percent of quota. Weaker-than-expected export prices and developments were the principal sources of the shocks. When adverse external shocks had dis- 5 ruptive effects on adjustment programs, they typically gave rise to additional financing needs for the balance of 0 payments and the budget. In particular, net shortfalls in 60 62 64 66 68 70 72 74 76 78 80 82 84 86 88 the external account were at times translated through price and output effects into a significant deterioration in the 1 Commodity price volatility is measured as the standard deviation of the 24-month percentage change in commodity prices expressed in fiscal position. Since the scope for quick and full off- SDRs. setting measures was often limited, it proved difficult to 2 Index of commodity prices excluding oil and gold and using ex- achieve the original program objectives or to comply with ports of developing countries as weights. the performance criteria established under Fund arrange- ments in the face of these adverse shocks. As a result, prices of individual commodities; for example, prices for a large number of program interruptions were typically beverages have shown greater variability than the aggre- 12 dealt with through understandings reached via the waiver gate index. Moreover, although commodity price vari- or modification process. ability initially declined from that experienced in the early 1970s, it has increased in the 1980s.13 In addition to international interest rates and industrial countries' exchange rates, non-oil commodity prices have Responses to External Risks also been affected on the demand side by the level of This experience raises questions about the measures economic activity and rates of inflation in industrial coun- countries can take to reduce their exposure to these risks. tries, and on the supply side by policies affecting levels Efforts to limit or offset the impact of external shocks of domestic production (particularly for agricultural com- have often focused on self-insurance, on official bilateral modities). or multilateral agreements or assistance, and on market- based hedging instruments. With regard to self- 12 Fluctuations in some commodity prices have reflected changes in insurance, developing countries have increasingly turned supply conditions, and the impact of price changes on export earnings has thus been dampened by variation in volume. 13 Similar results were obtained when the indices of volatility were calculated in terms of real commodity prices rather than nominal com- 14 A key issue is how adjustment efforts are affected by the combined modity prices, where real commodity prices were defined as nominal risks created by the interaction between interest rate, exchange rate, commodity prices divided by developing country import unit values. and commodity price variability. While the risks created by asset and For a more detailed discussion of commodity price developments, see commodity price variability could theoretically be offsetting, this has Boughton and Branson (1988). generally not happened in the 1970s and 1980s.

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©International Monetary Fund. Not for Redistribution II • FINANCIAL RISKS CONFRONTING INDEBTED DEVELOPING COUNTRIES toward export diversification—and, in particular, toward Official multilateral and bilateral agreements and as- diversification into manufactures—as a way of reducing sistance have also helped indebted developing countries the variability of export earnings. Producing and ex- to limit the effects of external shocks on their domestic porting a variety of products can offset the adverse do- economies. For one thing, there has been continued in- mestic consequences of short-run exogenous changes in terest in international commodity trading arrangements— supply or demand for individual products. A recent study and in buffer stocks in particular—that are designed to found that diversification into exports of manufactures reduce short-term fluctuations in the prices of primary contributes to reducing earning instability and also trans- commodities exported by the developing countries.17 Five fers the primary source of instability from supply to de- international commodity agreements with market inter- mand factors.15 Nevertheless, it is still true that the prices vention provisions are currently in operation: the Inter- of manufactured goods exported by developing countries national Sugar Agreement (1984), the International Natural seem to exhibit greater variability than those exported by Rubber Agreement (1979), the Sixth International Tin industrial countries and that export diversification takes Agreement (1981), the International Cocoa Agreement a long time to achieve: it should not be viewed as a short- (1980), and the International Coffee Agreement (1983).18 run measure to insure against external risks. During 1978-81, the five commodities covered by these A second way in which some countries have sought agreements accounted for about 35 percent of the earnings to limit the impact of external risks is to impose limi- of the non-oil developing countries from non-oil primary tations on external transactions. Exchange and trade re- commodity exports. Three of these commodity agree- strictions are often motivated by considerations other than ments—namely, sugar, tin, and natural rubber—are also to reduce external risks (for example, to protect sectors eligible for financing under the Fund's buffer stock fi- of the economy from foreign competition, to improve an nancing facility. unviable external position, and to limit capital flight), Another important vehicle by which the Fund has helped but restrictions have often remained in effect even when members to reduce fluctuations in the availability of for- they were no longer needed for those purposes or when eign exchange receipts is the compensatory financing their costs had become prohibitive. Nonetheless, some facility, which provides assistance to members experi- proponents of inward-looking policies have attached con- encing temporary shortfalls in their export income caused siderable importance to the view that a restrictive ex- by factors beyond their control. The decision on com- change and trade system serves to insulate the economy pensatory financing of fluctuations in the cost of cereal from external disturbances. imports, which was established in 1981 for a period of Yet a third approach to self-insurance is to improve four years and extended for a further four years ending the matching of the maturity and currency composition in May 1989, has provided compensation to members for of foreign asset and liability structures. The potential excesses in cereal import costs.19 More recently, agree- importance of this factor was amply demonstrated during ment has been reached on a new compensatory and con- the early 1980s when countries had a large mismatch tingency financing facility that would preserve the essential between the stream of returns on investment expenditures features of the compensatory financing facility, but would and the repayment structure of external loans. Moreover, also provide contingent financing for a wider range of the extensive accumulation of short-term debt became a external shocks, including export earnings, import prices, major cause of difficulty when short-term reserve assets and interest rates. Other current account transactions (such dried up abruptly. To prevent a repetition of such prob- as tourist receipts and migrant workers' remittances) can lems, countries have sought to avoid excessive short-term also be covered where they are of particular importance. debt accumulation and have rebuilt their holdings of for- All of this brings us directly to the main subject of this eign exchange reserves. At the same time, the potential beneficial contribution that a better matching of foreign asset and liability structures can make is constrained by the substantial borrowing needs and large existing ex- tied to either export prices or a country's export receipts. Greater ternal debt of developing countries and by their still low reliance on equity financing as opposed to external borrowing could 16 also potentially reduce exposure to interest rate risks. reserve holdings. 17 Some have expressed concern about how effective these arrange- ments have actually been in limiting commodity price variability. This concern reflects the difficulty with the Tin Agreement in 1985, the absence of price provisions in the current International Sugar Agree- 15 Bond and Milne (1987). ment, and the difficulties encountered in the International Cocoa 16 These risk management efforts have also included selecting an Agreement. appropriate currency composition of external debt, establishing debt- 18 An example of a regional stabilization program is the European equity swap programs, and purchasing crop-loss insurance on inter- Community's export earnings stabilization scheme (STABEX), which national markets. Moreover, some countries have negotiated linkages provides compensatory financing assistance to countries from Africa, between the amount of funding made available under new money the Caribbean, and the Pacific whose exports to the Community have packages to changes in international interest rates or prices (for ex- suffered a shortfall. ample, the price of oil). It has also been proposed that some developing 19 The oil facilities of 1974 and 1975 assisted members in financing countries could issue commodity-linked bonds whose return would be current account deficits resulting from the increase in oil prices.

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©International Monetary Fund. Not for Redistribution Responses to External Risks paper, namely, recourse to market-related hedging in- be utilized to deal with other foreign exchange reserves struments as further means of shielding indebted devel- and debt management problems. oping countries from volatility in external prices and assets. The next section closely scrutinizes hedging possibil- Until now, indebted developing countries have made only ities and benefits with a comprehensive look at the po- relatively limited use of financial market hedging instru- tential role of market-related hedging instruments in ments. Some have argued the correctness of this on the managing the financial risks faced by indebted devel- grounds that (1) these markets still lack a sufficient vol- oping countries. Attention is focused on those instru- ume of activity—especially at maturities that would be ments which are accessible to indebted developing countries most relevant for the hedging needs of these countries; and in which market activity is sufficient to make at least (2) obtaining the required degree of protection against modest hedging operations feasible. The costs and cash- external price shocks would be too expensive; and flow requirements associated with these hedging instru- (3) establishing the control and trading systems needed ments are also examined. Finally, the role such instru- to operate effectively in these markets would require us- ments might have in adjustment programs and debt ing scarce technical and financial skills that could better reschedulings is considered.

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©International Monetary Fund. Not for Redistribution III Market-Based Interest Rate Hedging

Development of Market-Based Hedging Appendix III discusses the use of commodity hedging Instruments instruments. Even when the focus is on managing interest rate risks, The pattern of price volatility experienced in the in- the hedger faces an extensive variety of standardized and ternational economy during the 1970s stimulated the search customized hedging instruments. In one sense, this ex- for new instruments and techniques to transform and real- tensive shopping list is deceiving, because even the most locate financial risks. This search was facilitated by the complex contingent contracts are generally "built up" more general process of financial innovation and liber- by combining two basic hedging instruments. One of alization,20 the weakening or elimination of capital con- these instruments involves using a contingent contract trols among the major industrial countries, and the that "locks in" a given interest rate. By so doing, it emergence of global trading in some of the more liquid allows the country to avoid the costs associated with a financial assets. The growing importance and usefulness higher interest rate. But it also requires the country to of hedging instruments—especially for institutional trad- forgo the benefits associated with a decline in interest ers and portfolio managers—have been shown by the fact rates. The oldest instrument of this kind is a forward that trading activity in the futures markets for some cash contract, which obligates the owner to buy (or sell) a instruments21 (for example, the long-term U.S. Treasury given asset on a specified date at a specified "exercise" 23 bond) is often larger than activity in the underlying cash price. The second instrument is a contingent contract markets. that involves paying a premium to a counterparty for Although a very broad range of markets and instru- assuming the risk of higher interest rates. The hedger ments can now be used to hedge asset and commodity thereby retains the benefits associated with lower interest price risks (see the appendices), the basic nature of the rates and still limits the risks associated with increases hedging instruments and strategies is generally quite sim- in interest rates. An option contract, which gives the ilar across different markets. In view of these funda- owner the right but not the obligation to purchase (sell) mental similarities and the significance of floating interest an asset, potentially provides a means of placing a ceiling rate debt in total liabilities of indebted developing coun- on interest rates for some period of time. Although an tries, this section focuses principally on the use of interest option contract is viewed in this analysis as one of the rate hedging instruments, although this focus does not fundamental building blocks for other more complex in- necessarily imply that they are more useful than com- struments, some have argued that the hedging charac- modity hedging instruments for a particular country.22 teristics of such a contract can be replicated by combinations of forward or futures contracts and holdings of risk-free securities. 20 These developments are described in detail in Watson and others Before the 1980s, most financial hedging instruments (1987). 21 were provided by financial institutions on an "over-the- Cash instruments are the instruments whose price or interest rate variations are being hedged. counter" (OTC) basis. In this way, the hedging instru- 22 Traders from developing countries have for some time been in- ment could be "customized" to the user's needs. Some volved to some degree in commodity futures markets. However, data on the nationality of traders (and on whether they are from the public or private sector) are not generally published. A study by Powers and Tosini (1977)—using confidential data from the Commodity Futures 23 A futures contract, which provides a similar means of locking in Trading Corporation for 1976—77—indicated that a significant per- an asset price or interest rate over some given period, has often been centage of open interest in a number of commodities traded on futures viewed as ". . .a series of forward contracts. Each day, yesterday's exchanges in the United States was held by traders from developing contract is settled and today's contract is written" (Black, 1976). This countries. For example, at one time during this period, 7 percent of reflects the daily marking to market of futures, which will be discussed the short interest in grains and soybean contracts was held by traders later in this section. When their price is being determined, more com- from Central and South America, which may well have reflected hedg- plex instruments (such as interest rate swaps) are often viewed as ing by wheat and soybean exporters. similar to a series of forward contracts strung together over time.

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©International Monetary Fund. Not for Redistribution Use of Market-Based Interest Rate Hedging Instruments

OTC products, such as interest rate and currency swaps, tions. Other exchanges, such as the CME, the London interest rate caps, and forward foreign exchange con- International Financial Futures Exchange (LIFFE), and tracts, have experienced rapid growth in recent years. the Montreal Exchange (ME), have also introduced trad- For example, the total amount of outstanding interest rate ing in currency option contracts. Debt option contracts and exchange rate swap agreements has grown to nearly were introduced in 1982 on the CBT with a contract on a trillion U.S. dollars, while the amount of LIBOR in- a long-term U.S. Treasury bond. A debt option contract terest rate caps currently outstanding is estimated to be gives the owner the option to buy (sell) a cash instrument, near $250 billion. such as a U.S. Government bond, or to buy (sell) a futures During the 1980s, the use of exchange-traded futures contract on such a cash instrument.26 Debt option con- and options contracts has expanded relative to the use of tracts have also enjoyed a significant expansion in recent OTC instruments. Exchange-traded contracts have two years (see Table 1). basic advantages over OTC instruments. First, they often provide the most flexible means of implementing hedging or speculative strategies because of their relatively liquid Use of Market-Based Interest Rate Hedging secondary markets, which derive from the use of stan- Instruments by Indebted Developing dardized contract terms. This allows hedgers and spec- Countries ulators to adjust their positions quickly as economic conditions change. Second, the credit risk associated with The potential usefulness of market-based interest rate payment obligations is minimized by using performance hedging instruments for indebted developing countries bonds (that is, margin requirements, discussed in more depends in a broad way on the benefits associated with detail below) that must be maintained on a daily basis greater certainty about debt-servicing payments and on and by having the exchange interpose itself as counter- the costs and availability of hedges of different maturities. party in all contracts. When the clearinghouse is the prin- As demonstrated below, factors such as the structure of cipal (or counterparty) in every futures transaction and external debt, the ability of particular instruments to gain option, contract performance is guaranteed by the re- access to the markets, the size and liquidity of the markets sources of the exchange rather than by any single indi- 24 for each hedging contract, the cost of using particular vidual trader (as with OTC contracts). hedging instruments, and the capacity to design and man- While exchange-traded commodity futures have a long age hedging programs—all count in the final benefit-cost history, the first financial futures exchange was the In- calculus. ternational Monetary Market (IMM), a subsidiary of the From the structure of a country's external debt one can Chicago Mercantile Exchange (CME), which opened generally deduce the potential maximum size of interest trading of foreign exchange futures in 1972. This was rate hedging operations, the currency in which the hedg- followed by the introduction of the first traded interest ing contracts would have to be denominated, the potential rate future by the Chicago Board of Trade (CBT) in 1975. maturities of the possible hedges, and the appropriate Subsequently, significant financial futures markets for index interest rates. Since the external bank obligations foreign exchange and government securities emerged in of indebted developing countries are primarily medium- Australia, Canada, France, Japan, the Netherlands, Sin- term floating interest rate instruments denominated in gapore, and the United Kingdom. The trading in some U.S. dollars and indexed to LIBOR with quarterly or interest rate futures contracts, such as the U.S. Treasury semiannual reset dates, a number of possible hedging bond and the Eurodollar contracts, has grown rapidly over 25 operations could be undertaken. One important consid- the past two years (Table 1). eration in selecting the appropriate hedging operation is The development of the financial futures markets has the covariance between the interest rate on the country's been paralleled by the growth of markets for financial debt and other variables (such as export prices and vol- option contracts. Financial options—that is, options on umes) that might also affect the country's ability to ser- currencies, debt instruments, and stock indices—were vice debt. If, for example, an increase in the interest rate introduced in the early 1980s. Trading in currency options were invariably associated with an increase in the price began in 1982 on the Philadelphia Stock Exchange, which of the country's major export commodity, the effects of has remained the most active exchange for currency op- these movements could be offsetting, leaving the coun- try's ability to service its debt unaffected. The need for hedging arises because this kind of covariance is never 24 In addition, only clearing members of the exchange are able to clear trades through the clearinghouse, and other members of the perfect; the size of the hedging position needed to offset exchange must transact through clearing members. Clearing members the country's interest rate exposure accordingly depends also impose margin requirements on their customers and are subject to net worth requirements and other conditions designed to reduce credit risks. 26 Such a futures option therefore allows the holder of the option to 25 Appendices I—III give details on the history of contracts and ex- acquire a futures contract when exercising the option, rather than the changes. underlying asset.

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©International Monetary Fund. Not for Redistribution III • MARKET-BASED INTEREST RATE HEDGING

Table 1. Trading Volume and Open Interest1 in Eurodollar Futures and ]Futures Options Contracts, 1981-87 Eurodollar Futures2 Eurodollar Futures Options3 Open interest Open interest Daily trading volume {End of period) Daily trading volume {End of period) CME4 LIFFE5 CME LIFFE CME LIFFE CME LIFFE

{Average number of contracts)

1981 948 1,461 1982 1,316 1,884 18,012 2,084 — — — — 1983 3,608 1,822 45,602 8,565 — — _ — 1984 16,032 4,047 85,100 9,998 — — — — 1985 35,320 5,076 121,537 17,740 2,949 235 43,077 3,991 1986 42,786 4,364 214,401 22,334 6,946 152 92,108 2,265 1987 79,665 6,859 253,004 26,666 10,158 — 69,792

1 Open interest is the total number of contracts not offset by an opposite transaction or fulfilled by delivery. 2 Each contract has a face value of $1 million. 3 Each contract is written on one Eurodollar futures. 4 Chicago Mercantile Exchange. 5 London International Financial Futures Exchange. on the degree of covariance between interest rates and liquidity occurring within the 3-10 year range. Money other relevant variables. center banks have generally acted as counterparties in The principal issues involved can be illustrated by con- well over 80 percent of all interest rate swaps. However, sidering both a short-term hedge of the LIBOR to be paid since an interest rate swap involves an exchange of debt- at the next interest rate reset date and a medium-term servicing obligations (the fixed interest rate borrower agrees hedge designed to limit the country's exposure to adverse to service the obligations of the floating interest rate bor- interest rate movements over a three-year period. Al- rower and vice versa), a swap is an effective hedging though these short- and medium-term hedging operations instrument only if each counterparty fulfills its debt- could potentially be carried out with a variety of different servicing obligations. As a result, most borrowers will hedging instruments,27 creditworthiness considerations, engage in a swap only when credit risk is perceived to position limits imposed by futures and options exchanges, be low, and indebted developing countries with debt- market liquidity for individual instruments, and the cost servicing difficulties have therefore not had access to this of using a given instrument will limit the set of instru- market.28 ments that are relevant. Certain other hedging instruments are not as directly Creditworthiness considerations directly limit access restricted by creditworthiness considerations. The futures to some hedging instruments. Creditworthy borrowers in exchanges, for example, have sought to minimize credit industrial countries often use the interest rate swap market risks by adopting margin calls, which involve both the to convert their floating interest rate debt into the equiv- posting of an initial performance bond (margin require- alent of fixed interest rate debt. In an interest rate swap, ment) when a contract is either purchased or sold and the the indebted developing country would make a stream of allocation to the margin account of the capital gains or fixed rate interest payments and receive a stream of float- losses on outstanding future contracts at the end of each ing rate payments over an agreed time period, while the business day. This practice limits credit risk by essentially counterparty (usually a bank) would receive fixed, and reducing the scale of potential losses29 and by shortening make floating payments. No actual principal would be the performance period to a single day. As long as a exchanged either at the beginning or at the termination hedger can meet these margin requirements on a contin- of the contract. A floating rate borrower can thus achieve uing basis, he can make use of the markets.30 Should the any desired medium-term lengthening of his interest rate hedger be unable to meet any daily margin calls, his period using an interest rate swap. Although the market position is immediately closed out by the exchange. The is an over-the-counter market, a significant amount of exchange then returns the balance in the margin account standardization in swap contracts and procedures has added after deducting any loss incurred on the hedger's position. greatly to liquidity in this market. Bid-ask spreads tend to be narrow, and maturities go to 20 years, with most 28 Techniques for dealing with credit risk in the swap markets (through collateralization or frequent marking to market of the contracts, for example) are being considered; see Folkerts-Landau (1989). 27 While this discussion of the short- and medium-term hedging op- 29 This is true to the extent that the potential range of price movements erations will focus on the liability side of a country's external financial becomes larger as the length of the performance period is extended. position, in designing the appropriate hedge, a country's holdings of 30 Margin calls on hedging operations are discussed in more detail foreign assets would also normally be taken into account. below.

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©International Monetary Fund. Not for Redistribution Short-Term Hedging Using Eurodollar Futures Contract

The state of market liquidity for a hedging contract is term U.S. Treasury bills and Eurodollar futures contracts, another potential limiting factor. Given the scale of the however, have much larger scales of activity. external debts of indebted developing countries, even Since much of the U.S. dollar-denominated floating modest hedging operations might in the long run exceed interest rate debt of the indebted developing countries is those typically undertaken by individual private sector indexed to LIBOR, the Eurodollar futures contract has financial or nonfinancial firms.31 In addition, most fu- certain characteristics that could potentially make it a tures and options exchanges establish position limits on useful short-term interest rate hedging instrument for these the holdings or sales of their contracts by any single countries. It represents an obligation to buy or sell at a trader. For bona fide hedging operations, these limits may predetermined price on a specified future date a Euro- be exceeded, subject to exchange approval based on an dollar time deposit with a maturity of three months that evaluation of the hedger's needs, his financial ability, is indexed to the three-month LIBOR.33 It has a face and market liquidity.32 Thus, even if market liquidity is value of $1 million. The purchase (sale) of a futures adequate for a given hedging operation, position limits contract results in a "long" ("short") position in Eu- could potentially constrain the scale of the operation. rodollars. The purchaser's position is considered long The costs of using a market-related hedging instrument because the contract implies that he will buy a Eurodollar include not only the usual transaction costs, up-front pre- time deposit at some point in the future. The seller's miums, and the costs of meeting margin requirements position is short because he has sold a Eurodollar time but also the personnel and equipment costs of monitoring deposit, which he may not yet own, with delivery at some and implementing a hedging program. The nature of these future date. costs is discussed later in this section. Sales of Eurodollar futures contracts can be used to "lock in" a particular level of LIBOR at some future date. As will be illustrated later, this lock-in occurs be- Short-Term Hedging Operations Using cause the effects of any increase in LIBOR on the hedg- the Eurodollar Futures Contract er's actual interest payments would be offset by profits on the hedger's short position in Eurodollar futures. Con- The short-term interest rate hedging instruments that versely, any decline in interest payments resulting from are most readily available to indebted developing coun- a decline in interest rates would generate offsetting losses tries are the futures contract on three-month U.S. Trea- on the hedger's short futures position. Hence, the use of sury bills, the futures contract on three-month Eurodollar the Eurodollar futures hedge can turn floating rate interest funds, and short-term interest rate caps provided by fi- payments into the equivalent of a fixed rate interest pay- nancial institutions. The market for interest rate options ment. does not yet appear to have sufficient volume to accom- modate even relatively modest hedging operations by indebted developing countries. The markets for the short- Characteristics of Eurodollar Futures Contract

Trading in Eurodollar futures contracts currently takes 31 Although market liquidity may be relevant in choosing the size of place on the Chicago Mercantile Exchange (CME), the a hedging operation, its importance should not be exaggerated. First, London International Financial Futures Exchange (LIFFE), hedging operations by indebted developing countries would probably and the Singapore International Financial Futures Ex- begin on a relatively small scale. Second, an indebted country would not plan to hedge its entire floating rate debt even in the long term, change (SIMEX). The CME and SIMEX have a linked clear- but only a fraction, depending on such factors as the costs of hedging, ing system making their respective contracts tradable on the covariance of interest rates with other relevant variables, and the each market. Twelve Eurodollar futures contracts are typ- country's creditworthiness. It is not of grave concern, therefore, if a market is not at present large enough to enable a large debtor country ically listed at any time, with specified delivery dates to cover its entire debt. Furthermore, the markets in financial futures ranging from three months for the nearest contract to and other hedging instruments have been growing rapidly in recent three years for the farthest. (Further details of the Eu- years, and this growth may be expected to continue, particularly as a result of their use by an increasingly wide range of hedgers. Market rodollar futures contract are given in Appendix I.) Once size and liquidity, therefore, are more likely to influence decisions a Eurodollar futures position is established, it can either concerning the market in which to hedge rather than whether to hedge. be adjusted or eliminated prior to maturity of the contract 32 In some exchanges, speculative position limits do not apply to traders who can prove that they are bona fide hedgers by establishing through an offsetting trade. Alternatively, the contract that a futures position offsets an existing cash exposure. Since the can be allowed to mature with a cash settlement occurring exchanges enforce the position limits, they also judge whether a par- at the end of the contract. Settlement of Eurodollar futures ticular position is justified as a bona fide hedge. But regulators oversee the decisions made by the exchanges, and they often provide a non- contracts on the delivery date is made in cash rather than exclusive list of hedging transactions, and a transaction not listed can be classified as a hedging transaction only if the trader files certain statements with the exchange. Nonetheless, a foreign government could 33 The sale of a Eurodollar contract could therefore involve the prom- qualify as a bona fide hedger if it satisfied the rules applied to other ise to deliver 12 months hence a Eurodollar time deposit with 3 months' traders. maturity. 11 ©International Monetary Fund. Not for Redistribution III • MARKET-BASED INTEREST RATE HEDGING through physical delivery, since Eurodollar time deposits Table 2. Eurodollar Futures Contract are nontransferable. Thus, futures contracts are used pri- Specification marily as a means of reallocating the risks associated with movements in Eurodollar interest rates rather than Contract size $1 million. as a means of transferring ownership of property. Price quotation Quoted in terms of an index (100 The Eurodollar futures contract is priced on an index minus rate of interest). basis, that is, the price is given as 100 less the three- Settlement Settlement is in cash according to the LIB OR for prime banks' month Eurodollar interest rate. Thus, for example, a fu- three-month Eurodollar time tures interest rate of 8.25 percent translates into a price deposit prevailing on the day of of 91.75 (Table 2).34 As a result of this pricing structure, settlement. the value of a short position in Eurodollar futures (that Delivery month March, June, September, and is, the sale of a Eurodollar future) increases (falls) when December. Eurodollar interest rates rise (decline). This inverse re- Last day of trading Second London business day before third Wednesday. lationship between the level of interest rates and the price of a contract explains why hedging against higher interest Minimum fluctuation in price 0.01 percentage point or $25. rates involves the sale of a Eurodollar futures contract Daily price limit No limit. (as interest rates rise, the higher interest payments are Margin requirement Initial margin, $750; maintenance offset by profits on the short position). margin, $500 a contract. Futures prices are determined on the floor of most futures exchanges through an open outcry auction system. The expectations of market participants about future de- Margin requirements can play an important role in velopments in interest rates are reflected in the prices of determining both the cost and the cash flow associated futures contracts.35 with using the futures market because the hedger may As noted earlier, the use of futures contracts requires need readily available assets or lines of credit to meet that margin requirements be satisfied on a daily basis. margin requirements as market interest rates change. For Both the purchasers and the sellers of futures contracts example, Table 3 illustrates how changes in market in- are required to meet so-called initial and maintenance terest rates could influence the margin account for a hedger margin requirements.36 On the CME, for example, the with a short Eurodollar futures position of 1,000 March initial margin for the Eurodollar futures contract is at 1989 contracts (face value of $1 billion), which were least $750 or 0.075 percent of the nominal amount of the originally sold at a price of $92 a contract. contract.37 In addition, the CME calls on members to When the contracts were sold on Day 1, the hedger replenish their margin deposits to the level of the initial had to make an initial margin deposit of $750,000 (the margins when these fall below $500 a contract (the so- maintenance margin would be $500,000).38 On the fol- called maintenance margin). lowing day, futures interest rates on three-month Euro- dollar deposits are assumed to have decreased by 5 basis points; the price of the contract, therefore, increased by 34 Each basis point change in the futures interest rate results in a 5 basis points. In the view of the futures exchange, the basis point change in the price of a contract and is worth $25 =0.01 hedger would have suffered a loss on his short position percent (a basis point change) times $ 1 million (the face value of the in the sense that the contract that he has sold would be 3 contract) times /12 (the maturity of a contract (three months) as a pro- more costly to buy back. The margin account of the portion of the year). 35 The interest rate on Eurodollar time deposits with a three-month hedger with a short position would therefore be debited maturity that are to be delivered six months hence will tend to be near with the loss that he had incurred as a result of the rise the interest rate for the three-month period beginning six months hence in the price of the futures contract ($125,000).39 Since implied in the term structure of the cash market yield curve. The difference in futures interest rates and the current interest rate on the the margin account of the hedger would have remained underlying cash instrument (that is, the basis) reflects the shape of the above the maintenance margin, no margin call would cash market yield curve or the "cost of carry" associated with being have been made. If the futures interest rates declined by long in the deliverable security until the contract delivery date. A positively sloped yield curve produces positive basis, while a nega- a further 7 basis points on the following day, the margin tively sloped yield curve produces negative basis. The technical aspects account of the holder of the short futures position would of the relationship between futures and cash market interest rates are discussed in Appendix I. 36 The concepts of initial and maintenance margins are those used on the CME. In contrast, only a single margin requirement must be satisfied on the LIFFE. 38 Margin deposits earn money-market interest rates and can be made 37 These margins are established by the exchange for contracts sub- in negotiable money-market securities. mitted to it by clearing member firms. In turn, these firms establish 39 As noted earlier, each basis point move in interest rates results in initial margins for their individual customers that are typically higher. a $25 change in the value of the contract, and, in this case, the move The size of the initial maintenance margins is related to the maximum of 5 basis points results in a $125 change in the value of each of the price movement allowed for this contract on the exchange during the 1,000 contracts. The margin account of a holder of a comparable long trading day or, if no price limits exist, to the expected price volatility. position would be credited with the same amount.

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©International Monetary Fund. Not for Redistribution Short-Term Hedging Using Eurodollar Futures Contract

Table 3. Margin Requirements Design of a Short-Term Eurodollar Interest Rate Hedge (In U.S. dollars) Daily Using Eurodollar futures contracts to hedge against an Resettlement unanticipated change in the LIBOR prior to the next date Margin Debit or Margin Price Account Credit Call on which the interest rate on a country's external debt is Day 1 92.00 750,000 to be reset would involve selling an appropriate number Day 2 92.05 625,000 -125,000 — of Eurodollar futures contracts. In this way, any increase Day 3 92.12 450,000 -175,000 300,000 in interest rates that resulted in higher debt-servicing pay- Day 4 92.12 750,000 — — ments would also generate offsetting profits on the coun- Day 5 92.00 1,050,000 300,000 — try's futures position. However, such a sale of Eurodollar futures contracts also means that any unanticipated de- cline in the LIBOR that would reduce debt-servicing pay- have been debited $175,000 at the end of that day. Since ments would also generate losses on the country's future the balance in the margin account would have fallen position. As a result, the lower interest rate cost would below the maintenance margin, the holder would have be offset by the losses on the futures contract, thereby been asked to replenish his account by $300,000 to the keeping the total cost of Eurodollar funds equal to the full initial margin of $750,000. interest rate contracted for in the futures contract. A fu- This cash flow aspect of futures contracts may present tures hedge therefore locks in a given cost of funds no a difficult operational hurdle for some potential users of matter which way interest rates move; that is, it is a futures markets. A holder of a short or long position in symmetric hedging instrument. futures contracts has to stand ready to pay the required To illustrate the effect of a futures hedge, consider a funds into the clearinghouse at short notice or see his theoretical situation in which the authorities wanted in futures position immediately sold off. It is necessary August 1988 to fix the level of interest payments that therefore to prearrange some form of financing or to have they would have to make in December 1988. Assume assets available to meet the potential cash flow require- the country has $ 1 billion of external obligations and the ments—done frequently by establishing a line of credit interest rate to be paid is the prevailing three-month at a commercial bank to be used specifically for this LIBOR plus 100 basis points. It is important to note that purpose. the authorities would only be able to lock in the three- In addition to meeting margin requirements, the user month LIBOR that the market anticipates would prevail of Eurodollar futures contracts must incur a brokerage in December. This rate would in general differ from the commission, which is about $20 a contract a round trip. three-month LIBOR prevailing in August. For example, Hence, the transactions costs associated with the buy and as indicated in Table 4, the three-month LIBOR in Au- sell cycle of 1,000 Eurodollar contracts (face value of gust 1988 was 8.75 percent a year, whereas the author- $1 billion) would be approximately $20,000. ities would only be able to lock in the higher rate of 9.2 The type of hedge that can be constructed using Eu- percent for December 1988. They might nonetheless choose rodollar futures is also influenced by the fact that most to lock in the higher, currently expected rate if they were of the trading activity is concentrated in the three or four concerned that interest rates might rise even further. If nearby contracts (that is, those with maturities between the interest rate reset date on the country's loan contract 3 and 12 months). The Eurodollar market is thought to matched the maturity date on the futures contract,41 then be sufficiently deep and liquid to absorb easily trades of a 9.2 percent LIBOR on $1 billion of external debt could 1,000 contracts ($1 billion face value) in a single ses- have been locked in by selling 1,000 December 1988 sion.40 Transactions of this size in contracts with matur- Eurodollar futures contracts at a price of 90.8. ities extending up to a year could reportedly be handled If the LIBOR stayed at 8.75 percent until December in the course of a normal business day. There is little 1988, then the higher futures rate (9.2 percent) that was trading in contracts extending beyond two years. locked in during August would imply that the hedger's effective interest rate would be 10.2 percent, or 45 basis points above the actual interest rate prevailing in Decem- ber (Table 4). This effective interest rate (10.2 percent) 40 Table 1 provides data on the recent average daily volume in Eu- would reflect both the actual interest rate paid to the rodollar futures contracts on the major exchanges. During 1987, for lender (9.75 percent—reflecting the sum of the actual example, average daily volume on the CME was nearly 80,000 con- tracts and on the LIFFE about 7,000 contracts. In early September 1988 on the CME, total open interest on Eurodollar futures contracts amounted to about 550,000 contracts, including open interest of ap- proximately 170,000 contracts maturing in December 1988, 110,000 41 The problems created when this is not so will be discussed below. contracts maturing in March 1989, 40,000 contracts maturing in June If transactions costs were included, the locked in interest rate would 1989, and 25,000 contracts maturing in September 1989. be 9.21 percent.

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©International Monetary Fund. Not for Redistribution III • MARKET-BASED INTEREST RATE HEDGING

Table 4. Illustration of Eurodollar Futures Hedge (August 1988 three-month LIBOR: 8.75 percent; December 1988 three-month Eurodollar futures price 90.80 on August 18, 1988) Three-Month LIBOR in December 1988 Up 2 percent Up 1 percent Unchanged Down 1 percent at 10.75 percent at 9.75 percent at 8.75 percent at 7.75 percent A. Reset interest rate (LIBOR + 1 percent) for three months beginning December 1988 (in percent) 11.75 10.75 9.75 8.75 B. Interest cost (in millions) for three months on $1 billion loan 29.38 26.88 24.38 21.88 C. December 1988 futures contract settlement price (100-LIBOR) 89.25 90.25 91.25 92.25 D. Profit (loss) a contract in basis points (90.80— settlement price) 155 55 (45) (145) E. Brokerage cost1 (in millions) 0.02 0.02 0.02 0.02 F. Profit (loss) on futures hedge in dollar terms (in millions) (1,000 contracts times profit (loss) a contract in basis points times $25 a 2 basis point) 3.88 1.38 (1.13) (3.63) G. Effective interest cost (B + E - F) (in millions) 25.52 25.52 25.52 25.52 H. Effective interest rate (in percent) 10.21 10.21 10.21 10.21

1 Brokerage cost assumed to be $20 a contract (round trip). 2 One basis point of a single three-month $1 million contract is $25.

LIBOR (8.75 percent) and the 100 basis point spread to one year hence) might therefore be difficult to manage be paid to the lender) and the losses incurred on the or even to put in place. To extend the period of hedging futures contract (equivalent to 0.45 percent). Transaction operations, a "stack" hedge is therefore often used. For costs would have only a marginal effect. On the other example, if the authorities desired to lock in the futures hand, if the LIBOR increased by 2 percentage points to interest rate for its next three quarterly interest rate reset 10.75 percent, the country would profit significantly from dates, they could sell three times as many of the nearest- the hedge. Its effective interest cost would then still be term three-month futures contracts as are needed to hedge 10.2 percent and would be 155 basis points below the the first reset date. They could then close out one third reset interest rate prevailing in December. of this position at the first reset date and roll over the If the authorities wanted to hedge the LIBOR index remaining position to the next nearby three-month con- for more than one quarterly interest rate reset date (for tract.44 This stack hedge procedure is repeated at each example, December 1988 and March and June 1989), interest rate reset date until the entire position is closed they could simultaneously sell 1,000 December 1988 fu- out. But the stacking approach itself suffers from two tures contracts, 1,000 March 1989 contracts, and 1,000 shortcomings. First, the high frequency of selling and June 1989 contracts.42 While the interest rates locked in buying futures contracts increases the transactions costs at each reset date would typically differ, such a "strip" of the hedge. Second, the prices for futures contracts that hedge would allow the authorities to be certain of the will be traded at the end of each quarter are uncertain.45 scale of their interest payments over the next year.43 It would not therefore be possible in general to fix com- One issue with using such strip hedges is whether suf- ficient liquidity exists for contracts with longer maturi- ties. The most active contracts in the Eurodollar futures 44 In terms of this example, this type of hedge strategy would involve markets are those with three, six, and nine months' ma- selling 3,000 December 1988 Eurodollar futures contracts in August turity. A strip hedge extending for more than a year 1988. In December 1988, a simultaneous purchase of 3,000 December 1988 futures contracts and a sale of 2,000 March 1989 contracts would (involving three-month Eurodollar contracts that mature be made. The purchase of the December contracts would represent the closing out of the hedge for the first quarterly reset date. The profits (or losses) arising from the difference between the price at which the 42 This example is based on quarterly reset dates with the index rate December 1988 contracts were initially sold in August 1988 and the being the 3-month LIBOR. Although the hedges would be somewhat purchase price in December 1988 would be used to offset any change more complicated, it would be possible to use similar operations to in interest costs owing to a move in market interest rates. In March hedge semiannual reset dates with the 6-month LIBOR or annual reset 1989, the hedging operation would continue with the simultaneous dates based on the 12-month LIBOR. purchase of 2,000 March 1989 futures contracts and the sale of 1,000 43 The decision on the length of the period over which interest rates June 1989 contracts. Finally, in June 1989, the hedge would be closed are to be hedged would in part reflect the country's ability to alter through the purchase of 1,000 June 1989 contracts. policies to cope with interest rate increases. An ability to adjust quickly 45 A particular problem if the term structure of interest rates "twists,'' to changes in interest rates would presumably tend to reduce the need with short-term interest rates remaining relatively stable and medium- for long hedges. and long-term interest rates rising sharply.

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©International Monetary Fund. Not for Redistribution Medium-Term Hedging Using Interest Rate Caps pletely the interest rates that would prevail at each of the on the reset dates for which the hedge was intended. An future reset dates. effective rate of 7.3 percent was locked in by this op- If there are large differences between the interest rate eration, thereby eliminating interest rate uncertainty for and maturity features of the futures contract and those that period. applicable to the underlying debt obligations, hedging The Central Bank of Chile has also recently engaged operations naturally become more complex. It may then in a new hedging operation aimed at reducing the un- be necessary to use some form of a "cross-hedge." As certainty of the LIBOR rates prevailing at the 1989 reset discussed in Appendix I, the construction of a cross-hedge dates. To this end, the authorities sold March and June involves considering such factors as the correlation be- 1989 contracts to hedge at least 50 percent of the debt tween changes in the interest rates on the futures contract of the Central Bank with reset dates occurring in January, and those on external debt and the relationship between February, March, and April. In addition, it has authorized the desired maturity of the hedge and the duration of the other public and private entities to hedge their floating futures contracts. If appropriately designed, such cross- rate liabilities.48 hedges can provide substantial short-run protection against interest rate variability—and this occurs even if the char- acteristics of the futures contract and the debt obligation Medium-Term Hedging Operation Using are quite different. Interest Rate Caps The hedging program undertaken by Chile is a recent example of the use of financial futures to hedge an interest But what if a debtor country is interested in obtaining rate exposure arising from floating rate external U.S. medium-term protection against a general upswing in in- dollar liabilities. About 87 percent of Chile's total me- terest rates? As already noted, borrowers that are per- dium- and long-term foreign debt is denominated in U.S. ceived to be creditworthy have often achieved such dollars. Until early 1988, interest payments on most of medium-term protection by converting their floating in- these loans were tied to the six-month LIBOR. Negoti- terest rate debt into fixed interest rate debt over a three- ations between the Chilean authorities and a consortium to ten-year period through interest rate swaps. However, of foreign banks resulted in approximately $9 billion of creditworthiness considerations would probably limit the external debt being converted to an annual interest rate access of indebted developing countries to this market. reset period starting in early 1988. The 12-month LIBOR Moreover, activity in Eurodollar futures contracts drops became the index interest rate. off sharply for maturities of more than 18 months. The 12-month LIBOR rates applicable to 1989 debt- Another route to obtaining medium-term protection service payments were to be set at various dates in Feb- against higher interest rates is to purchase an over-the- ruary, March, and April 1988.46 To eliminate some of counter interest rate cap, currently provided by several the uncertainties about the LIBOR prevailing at the reset major commercial banks and securities houses. The pur- dates in February and March 1988, the authorities sold chaser of the cap pays a premium related to the level at March 1988 futures contracts, whereas the reset dates in which the interest rate is capped, the length of time during April 1988 were hedged through sales of June 1988 fu- which the cap is in effect, and the expected volatility of tures contracts. Since 3-month Eurodollar futures con- the capped rate. If market interest rates exceed the cap, tracts were used to cross-hedge a 12-month interest rate, the cap writer will reimburse the cap holder for the in- it was necessary to sell a total amount of futures contracts terest cost above the cap. that equaled four times the underlying dollar amount of LIBOR caps were introduced in 1983, and it is esti- the loan ($6 billion of futures to hedge $1.5 billion of mated that $250 billion of such caps are outstanding. An loans).47 The brokerage cost of the hedging operation important advantage offered by caps is that they can was $30 a contract (round trip), and the initial margin of provide protection for up to ten years, though liquidity $1,500 a contract was met by depositing U.S. Treasury in the market for caps with a maturity of over five years bills. The sale of the futures contracts was spread over is limited. The ability of this market to absorb large orders a period of more than three weeks. The authorities closed for caps with maturities up to five years—without si- the futures position by buying back the futures contracts multaneously generating sharp changes in the cost of the cap—compares favorably with the ability of the Euro- 46 For example, the interest payments to be made in February 1989 dollar futures market to absorb short-term hedging op- would reflect the interest rate set in February 1988. erations. Contacts by Fund staff with market participants 47 The change in the price of a futures contract of a cash instrument suggest that caps on LIBOR for individual countries with for a given change in its interest rate varies with the maturities of the instrument. For example, the price change of a 12-month instrument a face value of $1-5 billion for five years could be pro- for a 1 percentage point change in interest rates will be about four vided without difficulty. As with traded options, the use times that of a 3-month instrument. As a result, hedging against move- ments in the 12-month LIBOR using futures contracts indexed to the 3-month LIBOR will require the use of four times as many 3-month 48 The Chilean State Copper Company (CODELCO) has also engaged futures contracts as the face value of the underlying debt. in hedging operations.

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©International Monetary Fund. Not for Redistribution III • MARKET-BASED INTEREST RATE HEDGING of caps allows for some flexibility in limiting protection the movement of the LIBOR, are illustrated in Table 6. to a range of interest rate values. For example, an in- For example, if the LIBOR remained unchanged at 8.75 debted country may seek interest rate protection only for percent, the purchase of a three-year 10 percent cap would interest rate values between 10 and 13 percent, and be raise the hedger's effective annual interest rate by 45 willing to accept only partial protection when rates exceed basis points above the prevailing market rate of 9.75 13 percent. The cost of interest rate caps increases with percent (LIBOR plus 100 basis points). If, on the other increases in the length of the coverage and with decreases hand, the market interest rate remained at 9.75 percent in the exercise interest rate. For example, in August 1988, during the first year, while increasing to 11.75 percent a three-year cap on the LIBOR at 10 percent (when during the last two years, the hedger's effective average LIBOR was about 8.75) would have cost the equivalent annual interest rate would be held at 11 percent—or 8 of 1.25 percent of the face value of the principal to be basis points below the average annual market interest rate. hedged; in comparison, a five-year cap at 10 percent If interest rates were to rise to 11.75 percent and remain would cost the equivalent of 3.00 percent of the face at that level for the life of the cap, the hedger's effective value of the principal (Table 5). average annual interest rate would be 11.42 percent, The effects of the purchase of a cap on the hedger's whereas the unhedged average interest rate would be effective interest rate, under various assumptions about 12.75 percent.

Table 5. Premiums for Interest Rate Caps on Three-Month LIBOR as of July 19881 Ceiling Interest Rate Maturity of Cap 7 percent 8 percent 9 percent 10 percent 11 percent 12 percent 13 percent One year 1.22 0.64 0.27 0.15 0.08 0.06 0.05 Two years 3.20 1.95 1.08 0.56 0.28 0.15 0.12 Three years 5.27 3.45 2.12 1.25 0.75 0.44 0.26 Four years 7.36 5.02 3.28 2.11 1.36 0.87 0.57 Five years 9.42 6.64 4.52 3.06 2.08 1.41 0.97 Seven years 13.69 10.11 7.31 5.28 3.83 2.79 2.05 Ten years 18.78 14.35 10.83 8.20 6.24 4.78 3.70

1 These premiums are expressed as a percentage of the face value of the loan whose interest rate is being capped and are an average of premiums quoted by major banks and securities houses in New York in mid-July 1988. The three-month LIBOR averaged 8.3 percent during this period.

Table 6. Illustration of Interest Rate Cap Hedge (August 1988 three-month LIBOR: 8.75 percent) Three-Month LIBOR During Period September 1988-September 1991 First year 11.75 8.75 8.75 8.75 7.75 Second year 11.75 10.75 8.75 8.75 7.75 Third year 11.75 10.75 10.75 8.75 7.75 A. Cost (in millions) of $1 billion three- year rate cap with a ceiling rate of 10 percent1 12.50 12.50 12.50 12.50 12.50 B. Loan interest rate (LIBOR + 1 percent) First year 12.75 9.75 9.75 9.75 8.75 Second year 12.75 11.75 9.75 9.75 8.75 Third year 12.75 11.75 11.75 9.75 8.75 Average annual loan rate 12.75 11.08 10.42 9.75 8.75 C. Interest cost {in millions) for three years on $1 billion loan2 382.50 332.50 312.50 292.50 262.50 D. Reimbursement payment from cap provider (in millions)3 52.50 15.00 7.50 — — E. Effective average interest cost (A + C - D) (in millions) 342.50 330.00 317.50 305.00 275.00 F. Effective annual interest rate (in percent) 11.42 11.00 10.58 10.17 9.17

1 The cap premium is inclusive of all transactions costs. 2 The interest cost is stated in current dollars. 3 Payable at the end of the year.

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©International Monetary Fund. Not for Redistribution Hedging Strategies and Adjustment Programs

Some Factors Limiting Use of Interest Rate hedging operations. Recent experience in some financial Hedging by Indebted Developing Countries firms has shown that potentially large trading losses are possible if internal controls are inadequate. Central con- While the examples above suggest that market-related trol mechanisms may be especially important if separate hedging instruments might provide indebted developing hedging operations are carried out by decentralized gov- countries with the ability to reduce their exposure to in- ernment agencies. terest rate risks, it is clear that a number of factors have worked to limit the use of such instruments.49 One con- sideration has been the cost of hedging. As already in- Market-Based Hedging Strategies and dicated, the use of products such as interest rate caps can Adjustment Programs require the payment of significant premiums up front, which may be difficult in an environment of already External shocks can make the design and implemen- heavy debt-service obligations. Although financial fu- tation of adjustment programs more difficult. In a me- tures contracts do not entail up-front premiums, they do dium-term framework, high variability of external interest expose the country to potentially large cash flow require- rates and goods prices makes the financing gap less pre- ments arising from margin calls. Whereas such margin dictable. In addition, the prospect of such external shocks, calls would occur only when market interest rates de- which can also affect domestic spending and output, inev- clined relative to the interest rates locked in by the future itably makes the specification of the time and scale of contract, they might still require the authorities to raise policy measures less precise. In such circumstances, ob- the necessary funding very quickly to prevent the closing taining some degree of insurance before the fact against out of the futures position.50 certain types of external shocks by using market-related A second consideration has been access to the markets hedging instruments can contribute significantly to the on a continuous basis. Creditworthiness issues have continuity of the adjustment effort. Hedging operations sometimes limited the use of certain potential instruments could help to avoid abrupt changes in financing require- (such as interest rate swaps). In addition, even for those ments, and, given the debtor countries' lack of access to instruments traded on organized exchanges, position lim- financial markets, could therefore be especially useful.53 its that restrict the number of contracts that can be sold Nevertheless, hedging operations must be seen as a com- by a single hedger could limit the potential size of hedging plement to—rather than a substitute for—an appropriate operations.51 set of adjustment policies. The complexities involved in the management of hedg- Although the issue of which hedging operation would ing operations are a third factor. Interest rate hedges potentially be the most useful can be specified only on generally require continuous monitoring and readjust- a case-by-case basis, certain general considerations bear ment, especially if the duration of the hedge extends on the use of hedging instruments in adjustment pro- beyond the short term. Such activity requires skilled per- grams. First, the value of a hedge depends directly on sonnel capable of dealing in wholesale hedging markets the benefits of being able to avoid sharp adjustments in on a continuous basis. While these hedging services can policies, as well as on the cost of using and accessing to some extent be purchased from various financial in- the hedging instruments themselves. Even when the ben- stitutions, even the evaluation of their quality and cost efits of hedging operations are perceived to be significant, requires considerable knowledge of market instruments initial start-up costs may indicate only a modest scale of and techniques.52 A further problem arises in designing operations. Since hedging operations require a highly and implementing internal control mechanisms that ef- trained technical staff, establishing a hedging system would fectively limit the activities of risk managers to legitimate therefore involve certain personnel, training, and equip- ment expenditures. A second consideration is that certain types of hedging 49 These factors are relevant for most developing countries, not only for those with large external debts. operations appear to be easier to incorporate into ad- 50 For countries with limited access to international credit markets, justment programs than others. For example, the recent any premium or cost that must be paid in the current period to alleviate Chilean operations suggest that the Eurodollar futures future risk will imply more current adjustment to pay for less uncer- market can be used to develop a short-term hedge against tainty about the magnitude of adjustment in the future. 51 As discussed in footnote 32, speculative position limits are applied LIBOR exposure through near-term reset dates. Such flexibly for bona fide hedging operations where there is an underlying hedging operations can help make short-term forecasts cash position that is being hedged. For example, although there is a of financing gaps more precise. Since short-term com- 5,000 Eurodollar futures contract limit for speculators on the CME, it did not constrain the hedging activities of the Chilean authorities. modity futures markets also have a high level of activity, 52 The staff of the World Bank's Financial Operations Department has provided technical assistance to a number of indebted developing countries on establishing the necessary institutional arrangements for 53 But the risk exists that the country may lock in a higher interest the successful management of hedging operations. These efforts will rate than would be paid if no hedging operation were undertaken (for probably be expanded. example, if interest rates declined during the hedging period).

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©International Monetary Fund. Not for Redistribution III • MARKET-BASED INTEREST RATE HEDGING similar commodity hedging operations could make export index.54 Having bank creditors supply interest rate hedges prices or import costs more certain in the near term. in the form of LIBOR caps as part of restructuring agree- However, given that the level of activity in futures con- ments has also been seen by some as an attractive addition tracts with a maturity beyond 12-18 months drops off to the menu of techniques for resolving debt problems. quite sharply, it may be difficult to extend any short- Such a step could be part of a more general approach to term hedges using futures contracts to a maturity com- structuring loan (or rescheduling) agreements to allow parable to the medium-term framework of typical Fund for more adequate hedging of financial risks. programs. Some medium-term protection—at least against Finally, although the use of financial hedging markets interest rate shocks—is potentially available through three- would not directly increase the scale of financing avail- or four-year interest rate caps, but these require paying able to indebted developing countries, it would restore up-front premiums that may be difficult for countries some access to international capital markets for debt man- experiencing external payments difficulties. The cost of agement purposes.55 In particular, a country could regain such caps could be reduced by establishing a "corridor" some influence over the proportions of its external lia- that limits the maximum protection the country receives. bilities with either floating or fixed (or capped) interest For example, a country might purchase full protection rates. against any increase in the LIBOR to a range of between 10 and 12 percent, but only partial protection for rates 54 If hedging operations were to be implemented by using futures above 12 percent. contracts, existing rescheduling agreements might have to be amended to allow for the issuance of collateralized debt if secured bank credit Some creditor banks have argued that the use of hedg- lines were to be used to manage the cash flows associated with margin ing instruments by indebted developing countries might calls. Such amendments were recently negotiated between Chile and its commercial bank creditors. help forestall the need to reopen restructuring agreements 55 Countries whose exposure to interest rate risks is reduced through in the event of unanticipated movements in the LIBOR hedging operations may also be perceived as more creditworthy.

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©International Monetary Fund. Not for Redistribution IV Summary

Periods of high variability in international interest creditworthiness considerations, modest use of certain rates, in primary commodity prices, and in exchange exchange-traded futures contracts and of over-the-counter rates of major currencies have featured prominently on instruments appears feasible. The potential usefulness of the economic landscape, and this variability has in turn such hedging operations would have to be evaluated on adversely affected the economic performance and ad- a case-by-case basis and would involve consideration of justment programs of indebted developing countries. the benefits and costs of insuring against external shocks. The vulnerability of these countries to external shocks The benefits are likely to take the form of alleviating reflects their relatively open (unhedged) exposure to potentially sharp adjustment in policies or in financing these risks. While export diversification, debt man- requirements when external shocks occur, thereby en- agement, and reserve accumulation help limit their ex- hancing the continuity of adjustment efforts. The cost of posure, and while official arrangements and facilities utilizing these markets includes transactions costs, mar- have been developed to provide some protection against gin requirements, and up-front premiums, as well as of these external shocks, the question arises whether these establishing, maintaining, and supervising trading op- countries could and should take better advantage of the erations. Since indebted developing countries differ sig- same market-related hedging that has increasingly been nificantly in their individual exposures to external shocks, utilized in industrial countries. and in their access to and preparedness for existing hedg- Although indebted developing countries' access to some ing instruments, the techniques outlined in this paper may market-related hedging instruments would be limited by be more appealing to some countries than to others.

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©International Monetary Fund. Not for Redistribution Appendix I Futures and Forward Markets

A futures contract is an agreement to buy or sell a number of units of foreign exchange at an exchange rate specified amount of a specific commodity or financial typically but not invariably quoted in terms of U.S. dol- asset at a stated price for delivery at a specified date in lars. Foreign exchange futures contracts are traded in the future. terms of a limited number of currencies, including deutsche Commodity futures are the oldest futures contracts. mark, Japanese yen, pounds sterling, French francs, Ca- Futures trading is carried on in a wide range of com- nadian dollars, Swiss francs, and Mexican pesos. Table A4 modities, including barley, beef, chickens, cattle, cocoa, contains a listing of some foreign exchange futures mar- coconut oil, coffee, copper, cottonseed, citrus, corn, cot- kets and the currencies that are traded there. ton, eggs, fishmeal, flaxseed, sorghum, gold, hogs, lead, Financial futures are promises to provide a particular lumber, mercury, oats, orange juice, palladium, plati- financial asset at a predetermined price at a specified date num, palm oil, petroleum, plywood, pork, potatoes, pro- in the future (or to pay the holder an equivalent sum of pane, rapeseed, rubber, rye, silver, soybeans, soybean money). There are futures contracts for a number of widely meal, soybean oil, sugar, tin, wheat, wool, and zinc. traded interest-bearing assets, including U.S. Treasury Table Al contains a listing of some futures markets in bills and bonds, Eurodollar deposits, sterling time de- which commodities of particular relevance to developing posits and gilts, Government National Mortgage Asso- countries are traded. Table A2 provides an example of ciation (GNMA) mortgage pass-through certificates, a commodity futures contract and the way in which its commercial paper, and Dutch, Canadian, Australian, New terms are specified. Table A3 measures the size of some Zealand, Japanese, and French Government issues. A important commodity futures markets in terms of open growing market in stock index futures also exists; they interest and the volume of transactions. provide the holder with a payment based on the level of There are also futures markets in foreign exchange, in a particular stock-price index such as the Standard and which transactors agree to purchase or sell a pre-agreed Poor's 500 Index, the Value Line Composite Average

Table Al. Some Commodity Futures Markets Relevant to Developing Countries Commodity Location I. Commodities Important as Exports of Developing Countries Cocoa London, New York, Paris Coffee Jakarta, London, New York, Paris, Sao Paulo Copper London, New York Corn Chicago Cotton Hong Kong, New York Petroleum London, New York Rubber Jakarta, Kuala Lumpur, Kobe, Singapore, Tokyo Silver Chicago, London, New York, Sydney, Tokyo, Winnipeg Soybeans Chicago, Hokkaido, Hong Kong, London, Tokyo Sugar Hong Kong, London, New York, Paris Tin London Wheat Chicago, Kansas City, London, Minneapolis, Winnipeg

II. Commodities Important as Imports of Developing Countries Corn Chicago Ocean freight Bermuda, London Petroleum London, New York Soybeans Chicago, Hokkaido, Hong Kong, London, Tokyo Wheat Chicago, Kansas City, London, Minneapolis, Winnipeg

Sources: Buckley (1986) and Labys and Pollak (1984).

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©International Monetary Fund. Not for Redistribution Futures and Forward Markets

Table A2. An Example of Specifications for a Futures Contract World Sugar No. 11 Contract unit 112,000 pounds (50 long tons) Price quotation U.S. cents a pound Minimum price fluctuation 1/100 cent a pound or $11.20 a contract Maximum daily price fluctuation 1/2 cent (50 points) above or below the previous day's settlement price. Limits are expandable in increments of 1/2cen t (50 points) to a maximum of 2 cents (200 points). Limits do not apply to the nearest two months. Trading hours 10:00 a.m. to 1:43 p.m. Trading is suspended at 1:43 p.m. and the closing call begins at 1:45 p.m. (Eastern time). Basic grade Raw centrifugal cane sugar based on 96 degrees average polarization. Delivery months Trading is permitted beginning 18 months prior to the expiration of the contract. The trading months are January (F), March (H), May (K), July (N), September (U), and October (V). Deliverable Argentina, Australia, Belize, Brazil, Honduras, Colombia, Costa Rica, Dominican Republic, El Salvador, Ecuador, Fiji, French Antilles, Guatemala, India, Jamaica, Malawi, Mauritius, Mexico, Nicaragua, Peru, the Philippines, South Africa, Swaziland, Taiwan Province of China, Thailand, Trinidad and Tobago, United States, and Zimbabwe. Delivery points A port in the country of origin or, in the case of landlocked countries, at a berth or anchorage in the customary port of export, f.o.b., and stowed in bulk. Delivery responsibility Deliverer shall be responsible for all expenses pertaining to delivery and loading of sugar into the vessel, including freight taxes and other taxes of the country of origin of any nature. Normal pilotage, wharfage charges, customs fees, and similar charges pertaining to the entry or exit of the vessel at loading port are for the account of the Receiver. The Receiver shall provide vessels suitable for the carriage of sugar. These vessels shall be ready to load at loading port on any day from the first calendar day of the delivery month, up to and including the fifteenth calendar day of the second succeeding calendar month. Speculative position limits 4,000 contracts net position in any one month. 6,000 contracts net total position. CFTC large trader reporting level 150 contracts or more. Last trading day Last full business day of the month preceding the delivery month. Notice day Next business day following last trading day.

Source: Coffee, Sugar, and Cocoa Exchange Inc., New York (1985).

Table A3. Some Commodity Futures Markets: Recent Size Commodity Contract Amount Open Interest1 Volume2 Cocoa (CSCE) 10 tons 35,690 9,158 Coffee (CSCE) 37,500 pounds 23,071 3,135 Copper (CMX) 25,000 pounds 30,884 10,706 Corn (CBT) 5,000 bushels 172,867 39,351 Cotton (CTN) 50,000 pounds 31,973 6,066 Crude oil (NYM) 1,000 barrels 167,862 49,843 Silver (CMX) 5,000 troy ounces 73,904 415,086 Soybeans (CBT) 5,000 bushels 162,790 73,546 Sugar, world (CSCE) 112,000 pounds 147,449 13,454 Wheat (CBT) 5,000 bushels 47,986 16,024 Wheat (KC) 5,000 bushels 22,614 5,487 Wheat (MPLS) 5,000 bushels 10,427 2,431 Wheat (WPG) 20 tons 8,541 751

Sources: Buckley (1986); and Wall Street Journal (New York), May 26, 1988. NOTES: CSCE = Coffee, Sugar, and Cocoa Exchange; CMX = Commodity Exchange; CBT = Chicago Board of Trade; CTN = New York Cotton Exchange; NYM = New York Mercantile Exchange; KC = Kansas City Board of Trade; MPLS = Minneapolis Grain Exchange; and WPG = Winnipeg Commodity Exchange. 1 Open interest, Tuesday, May 24, 1988. 2 Volume of trading, Tuesday, May 24, 1988.

Index, or the Financial Times-SE 100 share index. prices by open outcry in a trading pit, a practice designed Table A5 provides a listing of some financial futures to make the market's workings public and to minimize contracts traded in various centers, while Table A6 pro- the possibility of collusion; recently, however, there has vides an example of the terms of a particular financial been a tendency for pit trading to be supplanted by com- futures contract. puterized trading. The futures exchanges also establish Futures contracts are traded on organized futures ex- the form of the standardized contracts and specify the changes. The traditional practice has been to establish procedures whereby they are traded. The goal of stan-

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©International Monetary Fund. Not for Redistribution APPENDIX I • FUTURES AND FORWARD MARKETS

number of prices in the market, also makes it easier for Table A4. Some Foreign Exchange Futures market information to be disseminated and understood, Markets making different contract prices more readily comparable. Market Currencies Traded The clearinghouse is another distinctive feature of fu- Chicago (CME) Canadian dollar tures markets. When a futures contract has been traded, Deutsche mark both the buyer and seller have incurred obligations: the ECU French franc seller has agreed to deliver the specified goods or assets Japanese yen and the buyer has agreed to pay a specific amount for Pound sterling them. Each contract is then cleared: that is, the contract Swiss franc is backed—not by the resources of the individual trader Chicago (MIDAM) Canadian dollar Deutsche mark who initially made the contract—but by the much more Japanese yen extensive resources of the futures exchange itself. The Pound sterling exchange enforces the contract by requiring that each Swiss franc party deposit funds (margin) to guarantee fulfillment of London (LIFFE) Deutsche mark the obligation. If a trader goes bankrupt, it is the ex- Japanese yen Pound sterling change, rather than another trader, that incurs any losses Swiss franc resulting from that trader's inability to fulfill the contract; New York (FINEX) ECU but any resulting risks are limited by the posting of mar- U.S. dollar index gin. In addition, since the exchange maintains an equal Singapore (SIMEX) Deutsche mark number of contracts long and short—that is, for each Japanese yen contract cleared, the exchange incurs an equal and op- Source: Buckley (1986). posite obligation to the buyer and seller—the exchange NOTES: All currencies listed are traded against U.S. dollars. CME = is not exposed to risk from fluctuations in the price of a Chicago Mercantile Exchange; MIDAM = Mid-America Commodity contract. The clearinghouse system facilitates trading in Exchange; LIFFE = London International Financial Futures Ex- change; FINEX = Financial Instrument Exchange; and SIMEX = Sin- futures contracts by making them anonymous: there is gapore International Monetary Exchange. no need to assess the creditworthiness of another indi- vidual trader before buying or selling a futures contract. dardization is to ensure that the volume of trade in any An exception to the typical operation of the exchange one contract is large enough to provide competition among clearinghouse system is the London International Finan- traders, as well as to promote liquidity—that is, to make cial Futures Exchange (LIFFE). On LIFFE, the broker- it easier for any prospective seller to find a buyer, or vice member clears the transactions of his clients and acts as versa, at the prevailing market price. Supporting a limited counterparty for all their contracts; the individual trader's number of standardized futures contracts, by limiting the legal relationship is with his broker, rather than with the exchange. The overall position of the broker is estab- Table A5. Some Interest Rate Futures Contracts lished by netting out the long and short positions of all Instrument Trading Unit Market Where Traded his clients; the broker's net position, in turn, is cleared Commercial paper $3,000,000 CBT by the exchange. 30-day maturity Another important feature of futures markets is the Commercial paper $1,000,000 CBT practice of marking to market. When a transactor un- 90-day maturity CD $3,000,000 IMM dertakes a futures contract, he is required to post initial Three-month maturity margin, a sum of money required to guarantee fulfillment £250,000 LIFFE of the contract. Initial margin is generally about 2-3 Eurodollar deposit $1,000,000 IMM, LIFFE Three-month maturity percent of the face value of the contract. However, once GNMA CDR $100,000 CBT a contract has been made at the prevailing market price, U.S. Treasury bill $1,000,000 IMM any subsequent changes in the market price of the same Three-month maturity U.S. Treasury bill $250,000 IMM futures contract will affect the trader's position: for ex- One-year maturity ample, someone who has a long position makes money U.S. Treasury notes $100,000 CBT, IMM if the futures price rises and loses money if it falls. Mark- Four-six years' maturity U.S. Treasury bonds $100,000 CBT, LIFFE ing to market means that at the end of every day any 15-year maturity gains are added to a trader's accounts and any losses are Twenty-year gilt £50,000 LIFFE subtracted. In case of losses, a trader is required to put up more money to cover them, to preserve the value of Source: Andersen (1987). NOTES: CBT = Chicago Board of Trade; IMM = Chicago Inter- his position at some minimum level (the maintenance national Monetary Market; LIFFE = London International Financial margin). This requirement that the trader experiencing Futures Exchange; CD = certificate of deposit; GNMA = Govern- losses post additional margin permits a cash payment to ment National Mortgage Association; and CDR = collateralized de- pository receipt. the trader's counterparty who is experiencing a gain.

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©International Monetary Fund. Not for Redistribution Futures and Forward Markets

Table A6. Example of a Financial Futures Contract U.S. Treasury Notes (Chicago Board of Trade) Deliverable Grades: U.S. Treasury notes with a face value of $100,000 and a maturity of no less than six and a half years and no more than ten years from the date of delivery. The price at which a note with the same maturity (calculated in complete integral three-month increments to the first day of the delivery month) and the same coupon rate as the issue will yield 8 percent, according to note tables prepared by the Financial Publishing Company of Boston, Massachusetts, is multiplied by the settlement price to compute the amount paid for the note principal for invoicing purposes. Interest accrued on the notes shall be charged to the long by the short in accordance with Department of Treasury Circular 300, Subpart P. New issues of long-term U.S. Treasury notes that satisfy the standards in this regulation shall be added to the deliverable grade as they are issued. The Financial Instruments Committee or the Board shall have the right to exclude any new issue from deliverable status or to further limit outstanding issues from deliverable status. Delivery Months: March, June, September, and December. Delivery: Delivery is by Federal Reserve book entry wire transfer system with invoice adjusted for coupon rates and maturity. Price Quotations and Minimum Fluctuations: Quoted in percentage of par; e.g., 65 — 16 or 65 — 16/32, decimal equivalent = 0.655. The minimum fluctuation is 1/32 of a point ($31.25 a contract). Daily Limits on Price Movements: Maximum fluctuation a day is 96/32($3,00 0 a contract) above or below the previous day's settlement price. CFTC Speculative Position Limit: None. CBT Speculative Position Limit: 5,000 contracts. Margin Requirements: Initial margin $1,500 a contract; maintenance margin $1,000 a contract; hedging margin (initial and maintenance margin required by transactor classified by the CFTC as a "bona fide hedger") $1,000 a contract. Market Size: Volume of sales, 1985:2,860,432 Open interest, December 1985: 70,495.

Sources: Buckley (1986); and Chicago Board of Trade.

To ensure orderly trading and to restrict the gains and large number of pairs of currencies. Forward agreements losses that can be incurred in a single day—and thereby on interest rates are another important financial instru- the risk of bankruptcy faced by the futures exchange ment, which enable the purchaser to lock into a pre- itself—limits are generally imposed on daily price move- agreed interest rate at a specified date in the future: if, ments. Once the price of a futures contract reaches its at that date, the market interest rate exceeds the rate limit, trading is stopped. specified in the forward rate agreement, the seller of the Forward contracts, like futures contracts, are agree- contract must pay the buyer the difference (multiplied by ments to buy or sell a specified amount of a specified the face value of the contract); if the prevailing market commodity or asset at a specified location and date for rate falls short of the rate specified in the contract, the a specified price. The difference between forward and buyer pays the seller the difference. futures contracts is that forward contracts are not traded Futures and forward contracts also differ in terms of in organized exchanges but are offered (usually by banks) the degree of basis risk. The basis is the difference be- on an over-the-counter (OTC) basis. An individual or tween the price of a futures contract and the price of the firm wishing to undertake a forward contract will ap- underlying cash instrument. It approaches zero as the date proach a bank (typically by telephone) to obtain a quo- specified in the futures contract approaches (conver- tation. Because forward contracts are traded on a gence). However, if futures contracts are being used for decentralized basis rather than on an organized exchange hedging purposes, the cash instrument against move- and are priced individually rather than by open outcry, ments in whose price the hedge is being constructed may they are much more flexible: they can be tailored to the be different from that underlying the futures contract. needs of individual transactors. In addition, forward con- There are three important differences to consider: the tracts are traded in many more locations in different time settlement date for the futures contract may differ from zones: this permits forward trading to continue almost the date on which the individual's cash commitment arises; around the clock, whereas futures trading can only take the commodity or asset specified in the futures contract place while the market is actually open. On the other may differ from the one pertaining to the cash commit- hand, forward trading lacks the anonymity provided by ment; and the location specified in the futures contract the clearinghouse system: a forward contract entails a may differ from the one relevant to the individual (es- risk that the other party (the counterparty) will be unable pecially for commodities). To the extent that any of these to fulfill the contract. This counterparty risk limits the differences exist, the individual is engaging in cross- liquidity of forward contracts and excludes from the mar- hedging, which involves a basis that does not necessarily ket all but highly creditworthy transactors. converge to zero by the relevant date. To the extent that Forward contracts in foreign exchange are of consid- movements in the basis may be unpredictable, the hedger erable importance and can be made in terms of any of a faces basis risk, which cannot in general be eliminated

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©International Monetary Fund. Not for Redistribution APPENDIX I • FUTURES AND FORWARD MARKETS by hedging using existing futures contracts. In spite of contracts: since futures contracts are marked to market basis risk, cross-hedging is useful in reducing risk insofar daily, the gains or losses on these contracts accrue before as movements in futures prices are correlated with the the interest payments on the external debt are due. Hence, spot price movements against which an individual wishes any gains realized on the futures position can be invested to hedge. until the date at which debt interest is paid; likewise, any The following example illustrates cross-hedging. Con- losses will have to be financed until that date. It is there- sider a country with floating rate external debt on which fore important to take account of the timing of cash flows the interest rate is reset annually, indexed to the 12-month by including the present value factor in determining the LIBOR. Without a 12-month LIBOR futures contract, appropriate number of contracts with which to hedge. the authorities would have to cross-hedge using contracts The discussion above indicates how one could select on some other interest rate. In choosing the appropriate the optimal hedge ratio—the optimal ratio of the face instrument for cross-hedging out of the set of interest value of the hedge to that of the hedger's existing ex- rates for which futures contracts exist, they would try to posure. With simple hedging—that is, when there is a find an interest rate whose movements are closely cor- hedging instrument that corresponds exactly to the pro- related with those of the 12-month LIBOR. If they wish spective hedger's existing exposure—the optimal hedge to hedge a large amount of debt, they would also have ratio is one. In this case, all the risk can be eliminated. to choose a contract in which the volume of trading ac- With cross-hedging, however, the optimal hedge ratio tivity is sufficient to create a high degree of liquidity so (as determined by the formula presented above) may be that the market can absorb the proposed hedging oper- either greater or less than one. But even when a cross- ation without affecting the contract's price. (In practice, hedge is constructed optimally, it is necessarily an im- considering risk and liquidity, it is often preferable to perfect hedge: it is never possible to eliminate all of the construct a hedge combining positions in more than one risk. The remaining risk, which cannot be eliminated by contract, rather than being limited to a single contract.) cross-hedging, is in the nature of basis risk. Once the appropriate hedging instrument (the three- Basis risk is the disadvantage of the standardization month Eurodollar contract, for instance) has been chosen, provided by exchange-traded futures. In forward markets the number of futures contracts needed to produce the and other OTC markets, it is possible, at least in prin- desired hedge must be determined. Suppose that the three- ciple, to construct a perfect hedge, since the contract can month Eurodollar futures interest rate is equal to the Eu- be tailored to the transactor in terms of settlement date, rodollar rate that is expected to prevail at the contract's location, and other specifications. For instance, forward settlement date. If we make this assumption and if we contracts are available for distant dates in the future, for ignore the transactions costs of hedging, the optimal hedge exchange of "exotic" currencies that are not traded on is simply one that minimizes the hedger's risk. Other- the organized futures markets, and for interest rates other wise, there is a trade-off between risk and the expected than the ones commonly used. This flexibility makes it cost of hedging whose outcome depends upon the hedg- possible for the individual transactor to avoid all basis er's degree of risk aversion. In this case, the appropriate risk. But there may be a cost to this flexibility: if a number of contracts is the product of several factors: financial intermediary issues a standard forward contract, it can easily eliminate its own resulting risk exposure by N = (Fl/F2) x p x 8 x i|/ issuing a similar but opposite contract to another cus- where TV is the number of contracts required, F1 the face tomer, or by hedging through transactions in organized value of the debt to be hedged, and F2 the face value of futures markets or in other financial markets. If the in- each futures contract ($1 million in the three-month Eu- termediary issues an unusual contract designed to elim- rodollar contract). Here, |3 is the regression coefficient inate basis risk for a particular customer, it may be more of the interest rate of the hedging instrument on the in- difficult for it to hedge its risk through either of these terest rate to be hedged; the regression coefficient is a methods. The basis risk that is thereby transferred to the measure of the statistical relationship between the two intermediary may nevertheless be reduced or eliminated interest rates, which reflects both the closeness and the through diversification; the extent to which this is pos- magnitude of the relationship. In the example, a regres- sible depends in each case on the extent to which the sion coefficient of p = 0.5 indicates that a 1 percentage basis is correlated with the other risks to which the in- point increase in the three-month Eurodollar rate is, on termediary is subject. If, by tailoring a forward contract average, associated with a 1/2 of 1 percentage point in- to an individual customer, the intermediary has to incur crease in the 12-month LIBOR. The duration factor, 8 , some risk that cannot be diversified away, it will have reflects the fact that if the desired maturity of the hedge to be compensated for this risk, and this compensation is longer than that of the hedging instrument, more futures will increase the customer's cost of hedging. contracts will be needed to achieve the desired coverage. Transactions costs figure differently in exchange-traded The present value factor, i|i, reflects considerations about futures contracts and in forward contracts. With futures the financing of the cash flows associated with futures contracts, trade is generally executed by brokers who

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©International Monetary Fund. Not for Redistribution Futures and Forward Markets charge a commission for their service. Commissions are return obtained by holding the asset until the delivery charged on a round-turn basis. On the other hand, in the date specified in the futures contract. The possibility of OTC markets, transactions costs are incorporated into the interest arbitrage creates a tendency for cash and futures spread between the bid and ask prices quoted by invest- prices to differ only by the amount of these carrying costs. ment banks. The arbitrage relationship between a futures price and The determination of futures prices is the final im- the cash price of the underlying asset can also involve portant element in assessing the costs of hedging using the term structure of interest rates. Consider, first, a the futures markets. The futures price of a commodity simple example. An investor can lend for six months by or asset will in general differ from the spot price that either (1) buying six-month Treasury bills and holding will materialize at the settlement date. However, two to maturity or (2) buying three-month T-bills and buying mechanisms create a link between the futures price and a futures contract on three-month T-bills for delivery in the spot price. The first is the possibility of hedged stor- three months' time, taking delivery on the futures contract age for some commodities: if the currently prevailing spot and holding the delivered bills to maturity. Strategy (2) price plus the cost of storing the good until the settlement can be characterized as one of establishing a synthetic date is less than the futures price, a firm could without position that mimics the position established by strat- risk store the good, sell the futures contract, and make egy (1). This synthetic position implies a six-month yield delivery, taking advantage of this difference; this is known which is equal to as intertemporal arbitrage. Such behavior tends to drive 2{(1 + r /4)[l + (100 - P )/4] - 1} down the futures price and drive up the spot price until 3 3 the two differ only by the cost of storage. The resulting where r3 is the three-month yield and P3 the futures price price structure, with futures prices exceeding spot prices, of a three-month bill for delivery in three months' time. is known as a carrying charge market (or contango). If Following similar reasoning, the futures prices of the futures prices are not high enough relative to spot prices three-month instrument for other, more distant delivery to provide an incentive for storage, stocks of the com- dates can be used to construct synthetic yields for 9-, 12-, modity will be depleted, tending to drive down the spot and 15-month maturities. If these synthetic rates, implied price and drive up the futures price; if the elimination of by the current three-month rate and the structure of fu- all stocks of the commodity is not enough to restore a tures prices for the three-month instrument, are graphed carrying charge market, an inverted market (or back- against the corresponding maturities, the result is a syn- wardation) is said to exist. thetic yield curve (a strip yield curve). If the strip yield This discussion of storage has been framed in terms curve differs from the ordinary cash market yield curve, of commodities, but it can be extended to financial assets. there is an opportunity for arbitrage—which can be viewed, In particular, in the foreign exchange market the analogue for instance, as borrowing at the six-month rate to finance is the possibility of covered interest arbitrage. The cost the synthetic position described. Such arbitrage is risk- of "storing" a foreign currency is the difference between less, and thus tends to bring together the strip yield curve the interest rate that can be earned on assets denominated and the cash market yield curve. Discrepancies between in the foreign currency and the equivalent domestic rate; the two yield curves are typically explained by transac- if this interest differential (which can of course be either tions costs, liquidity considerations, regulatory con- positive or negative) were less than the futures pre- straints inhibiting arbitrage by institutional investors, and mium—the difference between the spot and futures ex- risks of being unable to maintain the futures half of an change rates—there would be a riskless opportunity for arbitrage position because of the practice of marking to profit by selling domestic currency assets, buying foreign market. currency spot, buying foreign assets, and selling foreign Yet another way of viewing arbitrage in financial fu- currency in the futures market. The argument is sym- tures is that one can use the term structure of interest metric if the premium is less than the interest differential. rates to construct a synthetic futures position. Consider, This mechanism generally brings about covered interest for instance, the following two alternatives for obtaining parity (aside from transactions costs). a three-month T-bill in three months' time: (1) buying a The same albeit more complicated principles apply to futures contract for a three-month T-bill with a delivery interest rate futures. For interest rate futures, one form date in three months' time, and taking delivery on the of intertemporal arbitrage is to purchase a financial asset contract, or (2) buying a six-month T-bill now while sell- and sell a futures contract on that asset; the asset can then ing a three-month bill short (that is, borrowing at the be delivered in fulfillment of the futures contract. Such three-month rate) and buying it back (repaying the loan) intertemporal arbitrage is profitable if the futures price at its maturity date (at which time the six-month bill exceeds the cash price by more than the cost of carrying originally purchased has a remaining maturity of only the asset. The relevant carrying cost (which may be either three months). The position constructed through strat- positive or negative) is the interest cost of borrowing to egy (2) mimics that established in strategy (1) and can finance the purchase of the financial asset, net of any thus be characterized as a synthetic futures position. The

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©International Monetary Fund. Not for Redistribution APPENDIX I • FUTURES AND FORWARD MARKETS cost of so acquiring a T-bill implies a synthetic futures one could purchase 112,000 pounds of sugar for October rate, known as the forward-forward rate; in this example, delivery at a price of $0.0928 a pound, making the total it is cost of one contract $10,393.60. The price of the October 1988 contract has fluctuated since the contract was first 4[(1 + r6/2)/(l + r3/4) - 1]. issued between a high of $0.1035 a pound and a low of Arbitrage tends to bring the futures rate and the forward- $0.07 a pound. Contracts for more distant months gen- forward rate into equality with each other, although they erally carry slightly higher prices, presumably reflecting may differ for the same reasons that cash and strip yield carrying charges. Open interest is highest in the October curves may differ. contract; in the July contract it is lower, suggesting that The second mechanism that establishes a relationship by late May many traders had closed out their July po- between spot prices and futures prices is the possibility sitions. Open interest is also lower in the more distant of speculation. Speculators in the futures market attempt months. The volume of trading was 11,682, about 88 to forecast the spot price that will prevail at the settlement percent of the outstanding contracts. date; if the futures price is less than their forecast, they In late May, one could purchase deutsche mark for would expect to be able to profit by buying in the futures December delivery for $0.5994 a mark (on May 25 the market, planning to sell at the spot price prevailing at spot mark was $0.5882). The rates increase as the de- the settlement date. This behavior tends to drive up the livery date becomes more distant, reflecting carrying futures price toward equality with forecasts of the spot charges (lower German than U.S. interest rates), expec- price. The argument is symmetric: if futures prices exceed tations that the mark would rise vis-a-vis the dollar, or predicted spot prices, speculators would sell in the futures some combination of the above. market (taking a short position), and this behavior would The Eurodollar futures market displays a much wider tend to drive down the futures price toward equality with range of delivery months—up to March 1991. The price the predicted spot price. Such behavior is risky: specu- quoted for a Eurodollar deposit is 100 percent minus the lators can incur losses if their forecasts are incorrect. It interest rate. For instance, one could purchase a Euro- has been suggested therefore that speculators may only dollar deposit for June 1989 delivery for 91.07, implying operate if they expect to receive a risk premium (that is, that one must pay $910,700 for a deposit whose face some minimum reward for incurring this risk), which value at maturity is $1 million; this implies that the pur- would limit the tendency for futures prices to be brought chaser could lock in a yield of 8.93 percent from June to equality with predicted spot prices. However, a risk until September 1989. Eurodollar futures prices fall as premium would not necessarily bias futures prices in one delivery dates become more distant; equivalently, yields direction rather than another: speculators must fill the gap rise as the delivery date becomes more distant. This sit- between hedgers on the long and the short sides of the uation is typical in the interest rate futures market, cor- market. As a first approximation, if there is more short responding to an upward-sloping yield curve; the structure hedging interest than long, the futures price must be less of futures prices shown in Table A7 indicates that the than the expected spot price to induce speculators averse strip yield curve is also upward sloping. to risk to take long positions; but the reverse is true if In conclusion, the costs of hedging using the futures there is more long hedging interest than short. In a more market have three elements. First, one must consider the careful analysis, the bias in futures prices would also present value of the gains or losses incurred through changes depend on the correlation between the unanticipated com- in the futures price between the date at which the futures ponent of the spot price and the returns on the rest of the position is opened and when it is closed. If speculators typical speculator's portfolio. The bias could be either are active in the market, these gains and losses should positive or negative. on average be zero. The trader experiences these gains The discussion of futures prices can be summarized as or losses as prices change each day: his account is marked follows: the possibility of intertemporal arbitrage implies to market and he is required to post variation margin to that the futures premium on a storable commodity or asset maintain his position. A second element is the present will be no more than the marginal cost of storage. The value of the commission that must be paid to a broker possibility of speculation implies that the futures price to undertake the purchase and sale of the futures contract. will differ from speculators' spot price forecast by no As commissions are charged on a round-trip basis, com- more than a premium required to induce the speculators mission need not be paid until the hedger's position is to bear the risk associated with taking a position in the closed out. Third, the impact on the hedger's cash flow market. Both of these tendencies limit the cost of hedg- of margin requirements can influence the overall cost of ing: if futures prices equal predicted spot prices, the cost hedging. Initial margin is refundable and interest is paid of hedging is simply the commission that must be paid on it, while variation margin reflects the gains or losses for buying or selling futures contracts. that are incurred daily as the contract's price changes; Table A7 presents some recent examples of futures neither of these margin requirements is therefore, in it- prices. For instance, at the close of trading on May 25, self, an additional cost to the hedger, as they are already

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©International Monetary Fund. Not for Redistribution Futures and Forward Markets

Table A7. Some Examples of Futures Prices (Data for Wednesday, May 25, 1988)

Delivery Daily Implied Lifetime Open Months Close Yield High Low Interest Sugar—World (CSCE) (112,000 pounds; U.S. cents a pound) July 9.22 10.38 6.79 29,404 October 9.28 10.35 7.00 67,944 March 1989 9.27 10.32 7.66 45,699 May 9.28 10.20 7.87 4,028 July 9.34 9.70 8.10 357 Volume: 11,682; open interest: 147,449 Deutsche mark (1MM) (DM 125,000; U.S. dollar a deutsche mark) June 0.5873 0.6494 0.5410 49,993 September 0.5934 0.6555 0.5609 9,482 December 0.5994 0.6610 0.5705 1,563 Volume: 19,356; open interest: 61,043 Eurodollar (IMM) ($1 million; points of 100 percent) June 92.33 7.67 92.38 92.32 112,574 September 91.79 8.21 91.85 91.76 128,388 December 91.46 8.54 91.51 91.45 55,904 March 1989 91.25 8.75 91.31 91.24 36,687 June 91.07 8.93 91.13 91.08 17,617 September 90.92 9.08 90.97 90.91 15,464 December 90.79 9.21 90.82 90.78 11,982 March 1990 90.67 9.33 90.72 90.67 15,217 June 90.56 9.44 90.61 90.57 12,077 September 90.46 9.54 90.52 90.47 9,788 December 90.36 9.64 90.42 90.37 9,167 March 1991 90.26 9.74 90.32 90.27 4,898 Volume: 76,424; open interest: 429,763

Source: Wall Street Journal (New York), May 26, 1988. NOTES: CSCE = Coffee, Sugar, and Cocoa Exchange; IMM = International Monetary Market. included in the expected present value of gains and losses creditworthiness. Hedging means undertaking a risk to associated with the futures position. But both affect his cancel out another pre-existing risk: thus any losses as- cash flow. A hedger with unlimited access to financial sociated with the hedger's futures position are offset by markets would care only about the net present value of gains associated with the pre-existing risk, and vice versa. his outlays and receipts, and would care only about the If these gains and losses are incurred at different times, timing of each to the extent that it affects the net present however, the hedger may need to have funds available value; cash flow can, however, be a significant issue for to cover some losses, while the offsetting gains will be a hedger whose access to financial markets is limited by realized only later.

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©International Monetary Fund. Not for Redistribution Appendix II Options Markets

An option gives the holder the right, but not the ob- that the option will be exercised. A common practice ligation, to buy or sell a good or financial asset at a known as covered writing is to hedge against this risk by specified price (the exercise price or strike price) at or taking an offsetting position in the underlying asset— until a particular date (the expiration date). A call option hedging a call option, for example, by holding securities gives the holder the right to buy a particular good or that can be delivered if the call is exercised. Writing an asset, while a put option gives the holder the right to sell. option without hedging (uncovered or naked option writ- To obtain this right, the holder of the option pays a ing) involves substantial, sometimes unlimited risk; only premium, which is given to the issuer of the option ir- highly creditworthy individuals and institutions are per- respective of whether or not the option is exercised. mitted to engage in this activity. An option is purchased in anticipation that it may be There are widely traded options on a variety of finan- advantageous to exercise the option (to carry out the cial assets, including interest-bearing assets and foreign purchase or sale to which the holder of the option is currencies as well as stocks and stock indices. Futures entitled) at or before the option's expiration date. The options, options to buy or sell futures contracts in com- purchaser need not actually exercise the option to capture modities or financial assets, are also widely traded. There this potential benefit: he could also resell the option, and are also options to buy or sell commodities directly, but the potential benefit of exercising the option is reflected these are less common on organized markets. There are in the market price. An American option may be exer- both options and futures options in foreign currencies. cised at any time until it expires, while a European option Table A8 presents a list of some futures options on com- may only be exercised at its expiration date. A call option modities and the major markets in which they are traded. is worth exercising at its expiration date if the market Table A9 lists some foreign exchange options and futures price of the good or asset exceeds the exercise price options. Table A10 lists some of the markets in which specified in the option contract; a put option is exercised options on interest-bearing assets are traded. at its expiration date if the market price is less than the Another important distinction is that between ex- strike price. If at any time an option is worth exercising change-traded and over-the-counter (OTC) options. Ex- rather than throwing it away, it is said to be in-the-money; for a call option, this occurs when the price of the un- derlying instrument exceeds the exercise price; a put op- Table A8. Some Commodity Futures Options tion is in-the-money if the exercise price exceeds the price Markets of the underlying instrument. If an option is not in-the- Commodity Contract Amount Open Interest1 money, it is said to be out-of-the-money or (if the exercise Cocoa (CSCE) 10 tons 5,136 calls, 2,605 puts price is just equal to the price of the underlying instru- Coffee (CSCE) 37,500 pounds 4,964 calls, 2,994 puts ment) at-the-money. Copper (CMX) 25,000 pounds 10,022 calls, 5,148 puts Because the option gives the holder the right but not Corn (CBT) 5,000 bushels 40,107 calls, 30,752 puts Cotton (CTN) 50,000 pounds 7,873 calls, 2,983 puts the obligation to trade, it offers an asymmetrical risk/ Crude oil (NYM) 1,000 barrels 87,394 calls, 94,272 puts reward profile. The holder's gains are greater, the deeper Silver (CMX) 5,000 troy ounces 2,808 calls, 12,713 puts in-the-money the option turns out to be at the expiration Soybeans (CBT) 5,000 bushels 88,789 calls, 52,495 puts Sugar (CSCE) 112,000 pounds 60,691 calls, 18,345 puts date; with a call option, potential gains are thus unlimited. Wheat (CBT) 5,000 bushels 9,301 calls, 9,197 puts The holder's potential losses, on the other hand, are lim- Wheat (KC) 5,000 bushels 2,090 calls, 1,169 puts ited to the option premium paid. Sources: Buckley (1986); and Wall Street Journal (New York), A person who sells an option (the option writer) does May 26, 1988. so to earn the option premium, in the hope that the option NOTES: CSCE = Coffee, Sugar, and Cocoa Exchange; CMX = will stay out-of-the-money and expire worthless (or at Commodity Exchange; CBT — Chicago Board of Trade; CTN = New York Cotton Exchange; NYM = New York Mercantile Exchange; least will not go deep enough into-the-money to offset and KC = Kansas City Board of Trade. the premium received). An option writer faces the risk 1 Open interest as of Tuesday, May 24, 1988.

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©International Monetary Fund. Not for Redistribution Options Markets

cussed in connection with futures and forward markets, Table A9. Some Foreign Exchange Options and standardization involves basis risk to the extent that the Futures Options price movements against which someone is trying to hedge Currency Trading Unit Exchange Where Traded may be imperfectly correlated with the price that is spec- Canadian dollar Can$50,000 ME, PHLX ified in the option contract. However, avoiding this basis Can$100,000 CME risk by obtaining a customized contract in the OTC mar- Dutch guilder $10,000 EOE ket may have a cost: an intermediary writing an option ECU $10,000 EOE contract generally tries to offset the resulting risk by French franc F 250,000 PHLX hedging in the organized options markets or in the market Deutsche mark DM 50,000 LIFFE for an underlying asset, but basis risk cannot be elimi- DM 62,500 PHLX nated in this way. To the extent that the basis risk is DM 100,000 ME DM 125,000 CME, LIFFE nondiversifiable, that is, insofar as it is correlated with Japanese yen ¥ 6,250,000 PHLX the other risks to which the intermediary is subject, the ¥ 12,500,000 CME, LIFFE intermediary will have to be compensated for bearing this $100,000 ME risk, and this compensation will add to the cost of hedging. Swiss franc Sw F 125,000 CME, LIFFE One kind of OTC option that is of particular relevance $62,500 PHLX $100,000 ME is an interest rate cap or floor agreement. An interest rate cap is essentially a put option on an underlying financial Pound sterling £10,000 EOE £12,500 PHLX asset: when the interest rate rises above a specified level £25,000 CME, LIFFE (implying that the asset price falls below the strike price), £100,000 ME the option can be exercised—enabling the holder to sell Source: Andersen (1987). the asset at the strike price (borrow at the ceiling rate of NOTES: CME = Chicago Mercantile Exchange; EOE = European interest). In this way, an interest rate cap can impose a Options Exchange, Amsterdam; LIFFE = London International Fi- maximum on the interest rate that a borrower must pay; nancial Futures Exchange; ME = Montreal Exchange; and PHLX = Philadelphia Stock Exchange. in return, the borrower must pay a premium. An interest rate floor agreement is equivalent to a call option on the underlying asset, written by the borrower: if the specified Table A10. Some Interest Rate Options interest rate falls below the floor, so that the price of the underlying asset rises above the strike price, the call is Underlying Instrument Trading Unit Exchange Where Traded exercised, enabling the purchaser to buy the asset at the Three-month Eurodollar $100,000 LIFFE strike price (lend at the floor rate of interest). This option U.S. Treasury notes $100,000 CBT U.S. Treasury bonds $100,000 CBOE, CBT, LIFFE therefore places a minimum on the interest rate that the U.K. long gilt £50,000 LIFFE borrower must pay; in return, the borrower receives a premium. Source: Andersen (1987). NOTES: CBT = Chicago Board of Trade; CBOE = Chicago Board The customer's creditworthiness is of asymmetrical Options Exchange; and LIFFE = London International Financial Fu- importance to a cap and to a floor: buying a cap is equiv- tures Exchange. alent to buying a put option and the premium is paid "up front" (which requires that the customer have the money change-traded options have the advantage of to pay the premium) but, once it is paid, the customer's standardization of contract form, strike prices, and ex- creditworthiness is not an issue. Selling a floor, on the piration dates as well as trading procedures; this stan- other hand, is equivalent to writing a call option: in some dardization brings with it the benefits of liquidity, sense, for the debtor, the call is hedged, since the pay- competition in price setting, and ready availability and ments made in case the option is exercised are offset by interpretability of information (as discussed above in con- the lower interest rate on the customer's original loan; if nection with futures markets). Options exchanges also the customer defaults on the original loan, however, this establish a clearing procedure: once an option has been hedge breaks down and the floor agreement becomes cleared, it becomes the obligation of the options exchange equivalent to naked call writing—an activity with poten- rather than of the individual who initially issued the op- tially unlimited risk. tion. If the holder of an exchange-traded option chooses Combining a cap and a floor results in a collar agree- to exercise it, there is a randomized procedure for as- ment, which keeps the borrower's interest cost within signing the option, that is, for determining which of the pre-specified bounds: it is equivalent to what in exchange- issuers of like options is required to fulfill the option's traded options markets is known as a cylinder (a com- terms. bination of buying a put option and writing a call option). As against the advantages of the standardization pro- A collar agreement is less expensive than a cap by itself, vided by exchange-traded options, OTC options can be because the premium received on the floor agreement is tailored to the needs of the individual hedger. As dis- set against the premium paid on the cap; in fact, a collar

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©International Monetary Fund. Not for Redistribution APPENDIX II • OPTIONS MARKETS

(like a cylinder) can, if desired, be constructed in such the option's price and the associated change in the price a way as to make its net premium cost zero. However, of the underlying asset, as given by the ratio "delta." since one ingredient of a collar is a floor agreement, and The relationship between the option's price and the price a floor can only be made by a creditworthy customer, a of the underlying asset is nonlinear, so delta changes (at collar agreement is also available only to the credit- a rate gamma) with changes in the price of the underlying worthy. asset; as a result, the proportions of the underlying asset The major element in the cost of using the options and borrowing would have to be adjusted continuously market is the options premium. An options premium is to mimic accurately the behavior of the option's price. determined as the price of an option in a competitive Because this continuously adjusting leveraged portfolio market, and thus depends on the option's value to a pro- of the underlying asset mimics the behavior of a call spective buyer. This value has two components: the in- option, it could be combined with writing a call option trinsic value is the value of being able to exercise the to construct a riskless arbitrage position (delta hedging)— option immediately—that is, the difference between the a form of delta hedging is actually used by issuers of strike price and the market price of the good or asset to OTC options to hedge their risks. Similarly, one could which the option applies—multiplied by the number of construct a riskless arbitrage position by buying a call units that the option entitles the holder to buy or sell. option and taking a short position in the portfolio that The intrinsic value of an in-the-money option is positive, reproduces the option's behavior. Tracing the way in while that of an at-the-money or out-of-the-money option which the proportions of different assets would have to is zero. In addition to the intrinsic value, an option also be adjusted to maintain such a riskless arbitrage position has a time value, which reflects the possibility that over is the basis of the modern theory of option pricing. the option's remaining life it may go even deeper into The foundation of the modern literature on options the money (or an out-of-the-money or at-the-money op- pricing is a paper by Fischer Black and Myron Scholes tion may go into the money). Time value cannot be neg- (1973): the Black-Scholes formula is a specific mathe- ative, since an option holder always has the choice of matical expression for the price of a European-style op- closing out an option position immediately and capturing tion. The Black-Scholes formula assumes: that frictions the option's intrinsic value. The option's time value ap- in markets for options, bonds, and the underlying in- proaches zero as the expiration date approaches. An op- strument are negligible; that there is a riskless interest tion that is deep in-the-money has high intrinsic value rate that is constant over the life of the option; that a but little time value, while an option that is out-of-the- riskless arbitrage position between options and the un- money has time value but no intrinsic value. derlying asset can be assembled (that is, that there are The theory of option pricing is based on the fact that no restrictions on short sales of options or the underlying an option is equivalent to a combination of other assets. instrument); that the underlying instrument bears no ex- To begin with, holding a call option is equivalent to plicit return (such as interest or dividend payments) over holding a position in the underlying good or asset com- the life of the option; that trading in markets for both bined with a put option with the same strike price; this options and underlying assets is continuous; and that the implies that one can deduce the price of a put option by price of the underlying instrument changes continuously knowing the price of a call option and the price of the at a random rate that is distributed log normally with underlying asset (for futures options, it is the price of the mean zero. Under these assumptions, the price of a Eu- futures contract, not the good itself, that is relevant). ropean call option is given by Next, the possibility of carrying out riskless arbitrage C = P N(X) - [e'rT]S N(X - oT1/2) between an option and the underlying asset—for in- stance, by buying a call option, immediately selling the where C is the price of the option, P the price of the underlying asset short, earning interest on the proceeds underlying instrument, S the option's strike price, r the from the short sale, and exercising the option at its ex- risk-free rate of interest, T the length of time until the piration date—places bounds on options prices. option expires, a the standard deviation of the price of Furthermore, the concept of delta hedging uses the fact the underlying instrument, and N(X) the standard cu- that the price of an option is related to the price of the mulative normal probability distribution; here, we define underlying asset. Changes in the option's price will in X = 1n (P/S[e-rT])/vTl/2 + (VI)CTTV2 . general differ from changes in the price of the underlying good or asset, because the option is more highly levered. Thus, the option's price is higher, the higher the price However, the behavior of an option price can be mim- of the underlying instrument and the lower the option's icked by holding a certain amount of the underlying asset strike price, showing that the option only has intrinsic financed by a certain amount of borrowing, provided that value to the extent that the price of the underlying in- the changes in asset and option prices are small. This strument exceeds the strike price. The more distant its means of reproducing the behavior of the option's price expiration date, the higher it is, corresponding to the idea makes use of the relationship between a small change in that an option has time value. The standard deviation of

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©International Monetary Fund. Not for Redistribution Options Markets the price of the underlying instrument is a measure of have higher premiums (both call or put premiums increase how variable or volatile is that instrument's price; a more moving rightward along a row). Finally, note that some volatile price (as reflected in a higher standard deviation) entries are blank: if an options exchange judges that there increases the value of the option. A longer time until is insufficient interest in a particular combination of strike expiration and a higher standard deviation of the instru- price and expiration date to ensure some degree of market ment's price increase the option's price for essentially liquidity, it does not open trading in that particular contract. the same reason: either factor makes it more likely that The other element in the cost of using exchange-traded the instrument's price will increase substantially over the options is the commission that must be paid in buying life of the option. Either factor also makes it more likely or writing the option. (With OTC options, the transac- that the instrument's price will decrease substantially, tions cost is incorporated into the premium quoted.) Com- but the option holder's position is asymmetrical: his po- missions on futures options are about the same as those tential losses are limited to the amount of the option on the underlying futures contract. premium, while his potential gains are unlimited. Finally, a higher interest rate increases the price of an option because, to duplicate an options position using the un- derlying instrument, one would have to borrow to finance a purchase of the underlying instrument (the option is Table All. Some Examples of Futures Option more highly levered than is the underlying instrument); Premiums a higher interest rate makes it more expensive to duplicate (Data for Wednesday, May 25, 1988) an option in this way, and thus makes the option more expensive. 1. Sugar—World (CSCE) (112,000 pounds; U.S. cents a pound) The Black-Scholes formula has opened up the literature Calls Puts on option pricing, which extends the formula to more Strike Price complicated situations and develops numerical methods July Oct. Dec. July Oct. Dec. of calculating the appropriate prices. Such methods are 8.00 1.24 1.42 1.54 0.02 0.17 0.27 8.50 0.77 1.03 0.05 0.34 used not only to explain the existing structure of options 9.00 0.38 0.86 1.03 0.20 0.60 0.76 prices, but also to guide issuers of options in deciding 9.50 0.14 0.63 0.42 0.85 what price to quote, and to aid prospective purchasers of 10.00 0.07 0.49 0.71 0.85 1.21 1.44 11.00 0.02 0.31 0.50 1.20 2.00 OTC options in determining whether a quoted price is 2.23 fair. 2. Deutsche Mark (IMM) An option premium must generally be paid "up front''; (DM 125,000; U.S. cents a deutsche mark) Calls Puts because it must be paid regardless of whether the option Strike is exercised, an immediate outlay is involved. On the Price June July Aug. June July Aug. other hand, once the premium has been paid, the pur- 57 1.73 0.01 0.05 chaser has no further commitment; the risks incurred are 58 0.77 1.48 0.04 0.15 0.31 59 0.11 0.75 0.96 0.38 0.41 0.62 limited to the amount of the option premiums. Examples 60 0.01 0.29 0.52 1.28 0.95 1.18 of some recent option premiums are given in Table All. 61 — 0.11 0.25 2.27 1.76 — For example, in late May, the right to buy 112,000 62 — 0.04 0.13 3.27 — — pounds of sugar at 9 cents a pound in October cost 0.86 3. Eurodollar (CME) cents a pound for a total premium of $963.20 a contract. ($1 million; pointsof 100 percent) The right to sell DM 125,000 at 0.61 cents a deutsche Calls Puts Strike mark in July cost 1.76 cents a deutsche mark, for a total Price June Sept. Dec. June Sept. Dec. premium of $2,200 a contract. The right to buy a Eu- 9175 0.58 0.32 0.31 0.004 0.27 0.59 rodollar deposit in December at 93.00 (implying an in- 9200 0.34 0.20 0.23 0.01 0.41 0.75 terest rate of 7 percent) cost 0.04 points, implying a total 9225 0.13 0.12 0.16 0.05 0.57 0.92 premium of $400 a contract. 9250 0.03 0.07 0.11 0.20 0.76 1.11 9275 0.01 0.04 0.07 0.43 0.98 1.31 Table All illustrates some of the patterns already dis- 9300 0.004 0.02 0.04 0.67 1.21 1.54 cussed: options that are further into-the-money have higher premiums (call premiums decrease down any given col- Source: Wall Street Journal (New York), May 26, 1988. NOTES: CSCE = Coffee, Sugar, and Cocoa Exchange, New York; umn as the strike price increases; the reverse is true for IMM = International Monetary Market, Chicago; and CME = Chi- put premiums). Options whose expiry date is more distant cago Mercantile Exchange.

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©International Monetary Fund. Not for Redistribution Appendix III Commodity Hedging: Examples

The following examples of commodity hedging use equal the prevailing spot price. The producer's profits or the prices prevailing on the Coffee, Sugar, and Cocoa losses will reflect any difference between the price at Exchange (CSCE) and the Chicago Board of Trade (CBT) which the contracts were sold ($0.0928 a pound) and the on Wednesday, May 25, 1988. price at which they are bought again; for example, the profits or losses for various hypothetical alternative spot prices that may emerge are shown in Table A13. Case 1: Commodity Exports The example in Table A13 illustrates an important as- pect of hedging. By definition, hedging means taking on Consider a sugar producer who plans to sell a shipment a risk that offsets an existing risk. Consider the third of 10,000 long tons (equivalent to 22,400,000 pounds) column of Table A13: it shows the profits and losses of sugar in October 1988. The price of raw sugar for resulting from the futures market position itself. This delivery in a port in the country of origin has recently position entails the possibility of substantial profits or been $0,091 a pound. However, it is possible that the losses: taking this position in the absence of an existing spot price in October will be either higher or lower. risk would constitute speculation. However, as the fourth Consider the alternative price outcomes and their impli- column shows, when this risky futures market position cations for the producer's revenues as shown in Table A12. is combined with the price risk initially faced by a sugar Clearly, a small difference in price can significantly in- exporter, the two risks exactly offset each other, leaving fluence the producer's revenues, and therefore also his the exporter with the certainty of earning net revenues ability to meet other financial obligations. The risk as- of $2,078,720. sociated with this price uncertainty is therefore of concern Clearly, the futures position has to be evaluated in the to the producer. context of the producer's overall position, rather than in One way to hedge against the risk associated with isolation. In particular, the wisdom of hedging is not fluctuations in sugar prices is to take a short position in contradicted by the fact that the hedge position may by the futures market. There is a futures contract for raw itself turn out to be a losing one. As the example indi- sugar, f.o.b. port of origin (Sugar No. 11; see Table A2) cates, the producer would, in hindsight, have been better for the month of October. Each contract is for the delivery off unhedged if the spot price in October turned out to of 50 long tons (112,000 pounds). The current October be above $0.0928; nevertheless, as the fourth column price is $0.0928 a pound. indicates, the hedge is perfectly successful in that it elim- The producer could sell 200 October Sugar No. 11 inates all the price risk to which the producer is subject. contracts short. This position can be reversed in October, That a riskless hedge can be constructed in this situ- by buying 200 October Sugar No. 11 contracts; by that ation results from assuming that the producer knows the time, the October futures price will have converged to quantity that he will be selling, that it is an exact multiple of the contract size, and that the quality, location, and delivery date of his product are the same as those spec- ified in an existing futures contract. These assumptions Table A12. Sugar Producer's Revenues imply that there is no basis risk, since in this case the Spot Price, October 1988 Total Revenue basis converges to zero as the October delivery date ap- (U.S. dollars a pound) (In thousands of U.S. dollars) proaches. 0.06 1,344 To take the futures market position described, the pro- 0.07 1,568 ducer would have to post initial margin. Initial margin 0.08 1,792 0.09 2,016 on the Sugar No. 11 contract was recently $3,500 a con- 0.10 2,240 tract, implying an initial outlay of $700,000 for 200 con- 0.11 2,464 tracts. In addition, changes in the futures price result in 0.12 2,688 the hedger's position being marked to market, requiring

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©International Monetary Fund. Not for Redistribution Case 1: Commodity Exports

entail a total premium outlay of $134,400. Alternatively, Table A13. Effects of Sugar Futures Hedge he could buy a put option that is further out-of-the-money, Spot Price with a strike price of $0.08, for a premium of $0.0017; October Revenue from Sale Profit (Loss) from in this case, the premium outlay for 200 contracts would 1988 of Own Sugar Futures Position Net Revenue be $38,080. Table A14 characterizes the producer's rev- (U.S. dollars a pound) (In thousands of U.S. dollars) enues under alternative price scenarios. 0.06 1,344 734.72 2,078.72 In this example, when an exporter uses options to 0.07 1,568 510.72 2,078.72 hedge against price uncertainty, not all of the uncertainty 0.08 1,792 268.72 2,078.72 about his revenue is eliminated. If the market price turns 0.09 2,016 62.72 2,078.72 0.10 2,240 (161.28) 2,078.72 out to be below the strike price of the put option, the 0.11 2,464 (385.28) 2,078.72 producer can exercise the option, and thereby maintain 0.12 2,688 (609.28) 2,078.72 his revenues at a minimum level. On the other hand, if the market price turns out to be above the strike price, that he post maintenance margin. The CSCE imposes a the option expires worthless and the producer loses what daily maximum of $0.005 a pound on price movements he has paid in options premiums; in that eventuality, in the contract; if the price changed by its daily maximum however, he could still take advantage of the higher pre- amount, this would require the hedger to post an addi- vailing price of sugar. Based on the data in Tables A12- tional $112,000 in maintenance margin on a single day. A14, three comparisons can be made. (1) Compared with The need to post margin thus impinges upon the hedger's going unprotected, the option involves sacrificing a lim- cash flow; for some hedgers, these cash flow implications ited amount of revenue in case the market price of sugar may be important in themselves, in addition to the gains turns out to be high (above the strike price), to obtain and losses that have already been considered. the right to be compensated if the price of sugar turns To complete a picture of the costs and benefits of out to be low (below the strike price); it is like buying hedging, the commissions paid to a broker to execute the insurance against unfavorable price movements at a fixed contract should also be considered. Commissions are cost. (2) Compared with hedging by using futures, op- charged on a round-turn basis and are collected after the tions involve sacrificing some revenue in case the market position is closed out. The CSCE does not fix commis- price of sugar turns out to be low (below the futures sions for its members, but allows them to be determined price), to preserve the right to profit if the price turns competitively; however, commissions have recently been out to be high; in effect, options allow the hedger to about $32 a round turn a contract. The total commission preserve a partly open position (to speculate). (3) Buying cost of the hedge described would thus be about $6,400. an option with a lower strike price sets a lower floor to Another question is whether a hedging position such the hedger's revenues. If the price of sugar turns out to as the one described can be established without disrupting be low, this works to the hedger's disadvantage; if it the market and moving the futures price against the hedger (that is, down). The 200 contracts prescribed is less than Table A14. Effects of Sugar Future Options the position limit of 4,000 contracts in any one month Hedge (or 6,000 in all months combined). But such a position Revenue is large enough that it would have to be reported to the Spot Price from Commodity Futures Trading Commission (the CFTC Large October Sugar Profit (Loss) Trader Reporting Level is 200 contracts or more if more 1988 Sale from Options Position Net Revenue than 100 contracts are acquired in a single week). From (U.S. dollars recent market data, it appears unlikely that 200 contracts a pound) (In thousands of U.S.dollars) would be enough to have an appreciable effect on market (Strike Price = $0.09) prices, compared to a daily trading volume of 13,454 0.06 1,344 537.6 1,881.6 and an open interest of 147,449 contracts. The possibility 0.07 1,568 313.6 1,881.6 0.08 1,792 89.6 1,881.6 of being constrained by position limits and/or of dis- 0.09 2,016 (134.4) 1,881.6 rupting the market is of more serious concern for a pro- 0.10 2,240 (134.4) 2,105.6 ducing country as a whole; for example, Brazil (the world's 0.11 2,464 (134.4) 2,329.6 0.12 2,688 (134.4) 2,553.6 largest producer and third largest exporter) would have had to sell about 50,000 Sugar No. 11 contracts to hedge (Strike Price = $0.08) its entire 1987-88 sugar exports. 0.06 1,344 409.92 1,753.92 An alternative method of hedging in the situation de- 0.07 1,568 185.92 1,753.92 0.08 1,792 (38.08) 1,753.92 scribed in the example involves the use of futures options. 0.09 2,016 (38.08) 1,977.92 The producer could buy put options on October Sugar 0.10 2,240 (38.08) 2,201.92 No. 11 futures at a strike price of $0.09 for a premium 0.11 2,464 (38.08) 2,425.92 0.12 2,688 (38.08) 2,649.92 of $0.006 a pound; buying puts on 200 contracts would 33

©International Monetary Fund. Not for Redistribution APPENDIX III • COMMODITY HEDGING: EXAMPLES turns out to be above the higher of the two strike prices native methods cover this situation: one, the strip hedge, under comparison ($0.09 in this example), the hedger would involve selling some of each of the contracts over benefits from the lower premium cost associated with a the relevant period—that is, some of the October 1988 lower strike price, while either option would expire and some of the March, May, July, and October 1989. worthless. If such a strip hedge can be constructed, it can provide Commissions on futures options are similar to com- protection against much of the price risk. The main im- missions on the underlying futures contracts. Thus, the pediment to assembling a strip is that the market for the commission cost of the futures strategy described would more distant contract months may be thin, or even non- be similar to that of the futures strategy (that is, about existent: for instance, in late May 1988, open interest in $6,400). Options commissions must be paid when the the July 1989 World Sugar contract was only 357 con- option is purchased, in contrast to futures commissions, tracts and the October 1989 contract was not yet avail- which typically need to be paid only when the position able. is closed out; thus the two strategies have different im- An alternative to the strip hedge is the stack hedge, plications for the hedger's cash flow. The other cash flow which involves taking a rather large position in a nearby difference is that the options premium must be paid when contract month and then rolling over this position suc- the option is purchased—requiring an initial outlay of cessively into later contract months. In the example men- $134,400 in this example if the hedger buys the option tioned above, a producer planning in May 1988 to make with the higher strike price—in contrast to the initial a series of three sugar shipments in the following No- margin outlay of $700,000 for the futures strategy. In vember, April, and August could begin by taking a large addition, with the options strategy, once the premium position in the October 1988 contract (which, with an and commissions have been paid, the hedger does not open interest of 67,944 contracts in late May, is very have any further obligation; with the futures strategy, he liquid). In July, he could roll over four fifths of this may be required to post maintenance margin of up to position into the March 1989 contract and, keeping me $112,000 in a single day (if the price rises by its daily remainder in the October contract, plan to settle in cash maximum amount of 1/2 cent a pound). when October arrives. He could repeat this procedure in In this example, the options strategy leaves the hedger December, rolling over three fourths of his March 1989 with a greater degree of uncertainty about his revenues position into the May contract and keeping the remainder than does the futures strategy; he pays an option premium for cash settlement in March. In February, two thirds of to obtain the right to profit from any favorable price the May position can similarly be rolled forward into movements. July; in April, half of the resulting July position can be rolled forward to October (the rollover dates are chosen arbitrarily in this example, but would have to be chosen Case 2: Timing of Exposure carefully in practice). The advantage of this strategy is that it provides a position that is rolled out evenly over An important feature of Case 1 is that the hedger ex- a succession of contract months, without the need to deal pects to sell his output at a date for which a futures at any time in the less liquid distant months; in effect, contract (or an options contract) exists. Since futures the positions taken in the earlier months are being used contracts exist for only a limited number of delivery dates as a hedge against movements in the futures price at (for sugar, a maximum of six, but in practice recently, which the later month positions can subsequently be taken. four a year) and do not extend very far into the future The drawback of a stack hedge is that the hedger faces (for sugar, a maximum of 18 months, but often in practice basis risk as his position is rolled over from one contract little more than a year), this is not always so. If a pro- month to the next: the prices of the contracts bought and spective hedger's existing exposure pertains to a date sold in each rollover may differ by an unpredictable amount. between the delivery dates of two existing contracts, he These rollovers also entail some additional transactions may wish to hedge by combining positions in both of costs. these adjacent contract months. For example, if a pro- Both types of hedges therefore have advantages and ducer plans to sell sugar in December, he can hedge by disadvantages. In practice, stack and strip hedges should combining short positions in both October and March not be viewed as alternatives, but as elements to be care- contracts. Such a strategy would eliminate much, but not fully combined as part of an overall strategy that effec- all, of the price risk; the remaining risk is classified as tively manages the hedger's risk at the minimum cost. basis risk. A more complex problem arises if a prospective hedg- er's existing exposure is associated with a more distant Case 3: Uncertain Output date or dates. As an illustration, consider a producer planning to sell some sugar in November 1988, some in The hedger's problem can be explored further by con- April 1989, and some in August 1989. Two basic alter- sidering the case of an exporter who is uncertain of the

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©International Monetary Fund. Not for Redistribution Case 3: Uncertain Output quantity that will be produced and exported. Uncertain or too small (if output is high). output is of obvious importance for many developing Under what circumstances is it appropriate to follow countries exporting agricultural commodities; given un- the hedging strategy of selling in the futures market a certainty about weather, pests, and other circumstances, quantity equal to expected output? This strategy mini- it is difficult to predict the quantity available for export. mizes the variance of the producer's revenues under two As a simple modification of the example considered conditions: one, if the prices and outputs that may emerge as Case 1, consider a sugar exporter who expects, on are distributed normally around their respective means average, to sell 10,000 long tons of sugar in October, (it is technically required that their joint third moments but is uncertain whether actual output will be 8,000 or be zero) and two, if the covariance between price and 12,000 long tons. The producer is concerned about his output is zero. The second condition is the more impor- total revenue from the sugar sale, and thus is faced with tant for our purposes: it implies that high prices are as both price and quantity uncertainty. There is no organized frequently associated with high outputs as with low out- market for hedging against variations in a particular pro- puts, and likewise for low prices. If the covariance be- ducer's sugar output; however, the existence of quantity tween price and output were negative, low output would uncertainty affects how the producer should deal with more frequently be associated with high prices and high price uncertainty. output with low prices. This would be so if there were Table A15 shows how the producer's revenues depend important shocks, such as weather affecting output in a on the price of the product when output turns out to be number of producing areas, so that each producer's output 8,000 or 12,000 long tons, respectively. The producer was associated with variations in the world supply of the can hedge by selling short in the futures market a quantity commodity, which in turn would affect world prices. In of the commodity equal to his expected output. If an this case, the short position in the futures contract that output of 8,000 and 12,000 long tons is considered equally is required to minimize the variance of the producer's probable, the expected output is 10,000 tons. The pro- net revenue is less than the average amount that he ex- ducer can therefore sell short 200 October Sugar No. 11 pects to sell (that is, the hedge ratio is less than one). In contracts. The profits and losses associated with this fu- the example, in the negative covariance case the out- tures position are the same as those given in Case 1, and comes with high prices and low quantities—in which the are included in Table A15. The net revenues associated producer turns out to be worse off in an already bad with this hedged position are calculated, and depend on state—are relatively more likely to occur. Alternatively, the level of output that materializes. if the covariance between price and quantity is negative, This example illustrates the difficulties associated with price and quantity variations tend to have offsetting ef- hedging against price movements when output is uncer- fects on the producer's revenues, thus lessening the need tain: it is not in general possible to eliminate all the risk for additional hedging. associated with price fluctuations. If output is high, the There may also be a positive covariance between price hedge may be inadequate to offset the effects of price and quantity, since high prices tend to be associated with variability: if output is 12,000 tons, the producer's net high outputs and low prices with low outputs—the sit- revenues still vary as the spot price varies. The futures uation if there were important variations in demand that market position may turn out to be too large, as when led both the price and the quantity sold to vary together. output is low. The profits or losses from the hedge then If the covariance is positive, the producer who wishes to exceed the variations in revenue that they are intended minimize the variance of his revenues should take a fu- to offset: when output is 8,000 tons, the producer's net tures position that is greater than his expected output, revenues actually vary inversely with the sugar price. As because he can use a price hedge to protect, to some can be seen, there is a trade-off between the concern that extent, against both price and quantity uncertainty. The the hedge may turn out to be too large (if output is low) optimal hedge ratio is then greater than one.

Table A15. Revenues Associated with Output Uncertainty Output = 8,000 Output = 12,000 Spot Price Profit (Loss) from October 1988 Futures Position Sales Revenue Net Revenue Sales Revenue Net Revenue (U.S. dollars a pound) (In thou sands of U. S. dollars) 0.06 734.72 1,075.2 1,809.92 1,612.8 2,347.52 0.07 510.72 1,254.4 1,765.12 1.881.6 2,392.32 0.08 268.72 1,433.6 1,702.32 2.150.4 2,419.12 0.09 62.72 1,612.8 1,675.52 2.419.2 2,481.92 0.10 (161.26) 1,792.0 1,630.72 2.688.2 2,526.72 0.11 (385.28) 1,971.2 1,585.92 2.956.8 2,571.52 0.12 (609.28) 2,150.4 1,541.12 3.225.6 2,616.32

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©International Monetary Fund. Not for Redistribution APPENDIX III • COMMODITY HEDGING: EXAMPLES

Another strategy that may be superior when output is in the prices of imports can have significant adverse ef- uncertain is one that combines futures with futures op- fects on debtor countries, as increases in import bills tions. Consider the following hedge in the situation given obviously reduce the countries' ability to service debt. in the example: the producer sells 8,000 tons of sugar Many of these imports are manufactured goods, for which (160 contracts) in the futures market, and buys put op- organized futures and options markets do not exist. Al- tions on another 4,000 tons (80 contracts) at a strike price though hedging may still be possible, it requires finding of $0.09 a pound. Table A16 shows the profits obtainable commodity contracts or other assets whose returns are from this strategy, depending upon the spot price and the correlated with the prices of the imported goods (cross- producer's output that materialize in October. hedging). Clearly, this combination strategy is not capable of Many developing countries are also major importers eliminating all the risk associated with both price and of some primary products. Developing countries are among output fluctuations. But it does provide some protection the world's largest importers of wheat and corn, and also against circumstances under which a pure futures hedge significant quantities of other food products. Many are may turn out to be too large (high price and low output) also heavily dependent on imports of petroleum and other or too small (low price and high output). The strategy products. Hedging against adverse movements in the prices puts a floor under the producer's revenues in each of of these commodities is possible within the existing mar- these eventualities. If there is a negative covariance be- kets. tween variations in price and output, these circumstances As an example, consider a wheat importer who is plan- are particularly likely to arise. That the strategy uses ning to purchase 2 million bushels of wheat in December options only to hedge the portion of the output that is 1988. Although spot wheat prices in late May were about uncertain reduces the overall cost of the hedge. $3.40 a bushel, wide fluctuations in price are possible: However, the commission cost and the initial outlay the second column of Table A17 indicates the cost of the on premiums and margin requirements are higher with wheat purchase under several alternative scenarios. this strategy than with the pure futures strategy. Since The purchaser can hedge against the possibility that a the hedger is purchasing a total of 240 rather than 200 high price of wheat will emerge by buying December contracts, the commission cost is about 20 percent higher, wheat contracts in the futures market. Wheat futures are which is also reflected in a larger initial outlay on pre- traded on a number of different markets, including the miums and margin. Chicago Board of Trade (CBT), the Kansas City Board This example illustrates that hedging against com- of Trade, and the Minneapolis Grain Exchange; prices modity price uncertainty is a worthwhile objective, but on the CBT are used in this example because it is the some careful consideration is required to put it into prac- largest of the three markets. The December wheat price tice. The covariances among different risks are worth on the CBT recently closed at $3.62: the existence of a considering, as are ways in which different hedging in- premium in the futures market reflects the cost of storing struments can be combined. A hedging strategy must wheat between May and December. Each contract is for always be judged with reference to its implications for 5,000 bushels, so the importer would buy 400 contracts. the hedger's overall exposure to risk, not in isolation. The third column shows the profit or loss associated with this futures position in itself and the fourth shows the net revenue associated with this hedge. Hedging using fu- Case 4: Commodity Imports tures can eliminate the risk associated with an increase in the price of wheat-- while also, of course, eliminating Since many developing countries are heavily depen- the possibility of benefiting from being able to purchase dent on imports of food and other commodities, increases wheat at an unexpectedly low price. This is seen by

Table A16. Effects of Sugar Futures or Options Hedges with Output Uncertainty Profit (Loss) Profit (Loss) Spot Price from Futures from Options Net Revenue Net Revenue October 1988 Position Position (Output = 8,000) (Output =12,000) (U.S. dollars a pound) <------(In thousands of U.S. dollars) ------> 0.06 587.78 215.04 1,878.02 2,415.62 0.07 408.58 125.44 1,788.42 2,415.62 0.08 229.38 38.84 1,698.82 2,415.62 0.09 50.18 (53.76) 1,609.22 2,415.62 0.10 (129.02) (53.76) 1,609.22 2,505.42 0.11 (308.22) (53.76) 1,609.22 2,594.82 0.12 (487.42) (53.76) 1,609.22 2,684.42

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©International Monetary Fund. Not for Redistribution Case 4: Commodity Imports

Table A17. Effects of Wheat Futures or Options Hedges Profit Profit (Loss) (Loss) Cost of from from Spot Price Wheat Futures Net Options Net October 1988 Purchase Position Expense Position Expense (U.S. dollars a bushel) < (In thousands of U.S. dollars) -> 2.50 5,000 (2,240) 7,240 (660) 5,660 2.75 5,500 (1,740) 7,240 (660) 6,160 3.00 6,000 (1,240) 7,240 (660) 6,660 3.25 6,500 (740) 7,240 (660) 7,160 3.50 7,000 (240) 7,240 (460) 7,160 3.75 7,500 260 7,240 40 7,460 4.00 8,000 760 7,240 540 7,460 4.25 8,500 1,260 7,240 1,040 7,460 4.50 9,000 1,760 7,240 1,540 7,460 examining the importer's net expense, which is held at cents a bushel applying to Toledo deliveries). An im- $7,240,000 regardless of the spot price of wheat that porter in a developing country may be concerned with emerges. the price of a different grade of wheat for delivery in a Margin requirements for wheat futures were recently different month in a different location--for instance, the set at a minimum of $1,800 a contract; thus the total price of soft wheat for delivery in Bur Sa'id in January. initial margin for this hedge would be $720,000. Main- The difference between that price and the price of the tenance margin is also set at a minimum of $1,800 a March CBT wheat futures contract in January is the rel- contract. At a commission rate of $30 (round turn), the evant basis. The basis generally reflects the cost of stor- commission cost of purchasing 400 contracts would be age (including the interest rate), the cost of transportation, $12,000, which would have to be paid when the position the relative value that the market attaches to the different is closed out. characteristics embodied in different grades or types of An alternative hedging technique involves purchasing a commodity, and the market's expectations about im- call options on 400 December wheat futures contracts. pending changes in supply and demand for the product. December futures call options at a strike price of $3.40 If the basis is just a constant price differential, it is not were recently trading at $0.33 a bushel. Thus the total of great concern to the hedger; in that case, the importer cost of purchasing these call options would be $660,000. can still eliminate all the risk using futures contracts. The effect of this options hedge on the net cost of the However, if there may be changes in the costs of trans- wheat imports is also shown in columns 5 and 6 of portation, storage, etc. that may lead to unpredictable Table A17. This hedge has the effect of putting a ceiling changes in the basis over time, there is basis risk asso- on the net expense of the wheat purchaser: the purchaser's ciated with hedging using organized futures and options maximum expense is $7,460,000. On the other hand, the markets. It is thus not possible to construct a perfect purchaser can still take advantage of a fall in wheat prices. hedge. But, the hedger can still eliminate much of the The net cost of the wheat purchased is lower if the spot risk associated with price fluctuations to the extent that price turns out to be below the option strike price of the price of the hedging instrument is correlated with the $3.40; the importer's cost of hedging is thus limited to spot price of concern to the hedger. In this case, the the $660,000 that must be paid for the options premiums optimal hedge ratio depends on the regression coefficient (as well as commissions of about $12,000). of the relevant spot price on the futures price. Basis risk may be another important factor for the Basis-priced contracts can also be used to avoid basis wheat importer. The wheat futures contract traded at the risk. For instance, an importer who knows that he will CBT is for delivery of any of a number of varieties of have to buy soft wheat in Bur Sa'id in January can make wheat typically grown in North America: No. 2 Soft Red, a contract in May to buy that wheat for 17 cents above No. 2 Dark Hard Winter, No. 2 Hard Winter, No. 2 the CBT March wheat price prevailing at that date in Yellow Hard Winter, No. 2 Dark Northern Spring, No. 1 January. The exporter and importer are thus agreeing in Northern Spring, or No. 2 Heavy Northern Spring, with advance to the basis, and are left bearing the risk of substitutions at differentials established by the exchange. fluctuations in the CBT March wheat price. They can Delivery months are July, September, December, March, then make whatever arrangements they choose to hedge and May. Delivery must be made by delivering ware- against movements in the CBT March wheat price itself. house receipts issued against stock in warehouses ap- As these examples indicate, futures and options mar- proved by the exchange in the Chicago Switching District kets offer facilities that developing countries may use to or Toledo Ohio Switching District (with a discount of 2 protect themselves against commodity price movements

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©International Monetary Fund. Not for Redistribution APPENDIX III • COMMODITY HEDGING: EXAMPLES that may affect them either as importers or as exporters, be trained in the use of hedging techniques as well as in as well as to protect against adverse interest rate and market conventions and procedures. When approached exchange rate movements. In practice, the use of these with due circumspection, these markets may be of con- markets is not as straightforward as the simplest examples siderable use to debtor countries that wish to prevent their would suggest, but properly implemented trading strat- adjustment efforts from being disrupted by adverse price egies can cover many of the complications. Staff should movements.

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©International Monetary Fund. Not for Redistribution Appendix IV Glossary

American option: An option that may be exercised at Black-Scholes (also Black-Scholes model): A widely any time up to and including the expiration date. used option pricing equation developed in 1973 by Fischer Arbitrage: Trading strategies designed to profit from Black and Myron Scholes. Used to price over-the-counter price differences for the same or similar goods (assets) options, value option portfolios, or evaluate option trad- in different markets. Historically the term implied little ing on exchanges (see Appendix II). or no risk in the trade, but more recently it has come to Break-even point: The price of the underlying instru- include strategies that entail some risk of loss or uncer- ment at which an option buyer could just recover the tainty about total profits. (For two arbitrage strategies in initial outlay or premium by exercising the option: for a options, see Conversion and Reverse conversion.) call option, the exercise price plus the premium; for a put option, the exercise price minus the premium. Asking price: The price at which sellers are willing to trade; usually accompanied by a bid—the price that buy- Broker: (1) A person paid a fee or commission for act- ers are willing to pay. The bid price is often a better ing as an agent in making contracts, sales, or purchases; indication of the true market level. (2) a "floor" broker: a person who actually executes someone else's trading orders on the trading floor of an At-the-money: When the price of the underlying instru- exchange; and (3) an "account executive": the person ment is very close or equal to an option's exercise price. who deals with customers and their orders in commission Backwardation: See Inverted market. house offices. Basis: (1) The spread or difference between two market Bull: A trader or market analyst who feels that prices prices or two interest rates, particularly the spread be- will rise. tween a futures price and the cash price of the underlying Call option: See Option. commodity or asset; and (2) in certain other uses, a con- cise expression of what might more completely be ex- Carrying charge market (also normal market or con- pressed as "is based upon the following conditions"; for tango): A situation in which prices are higher in the example, "price basis delivered Chicago, Illinois, reg- forward delivery months than in the nearby delivery istered in owner's name ..." means that the price being months. Normally in evidence when supplies are ade- quoted is based upon those conditions being met. quate or in surplus. The price differential reflects either wholly or in part the costs of storing the commodity Basis-priced contract (also basis quote): Offer/sale of between the earlier and the later months. cash commodity as a difference above or below a futures Carrying charges: The costs of storing the cash com- price. modity; they include the physical storage costs, insurance Basis risk: The risk associated with the possibility that costs, and an opportunity cost for the interest lost on the the futures price fails to equal the relevant cash price by money tied up in the commodity. the time that a hedger closes out his position: the risk Cash settlement: The settlement provision on some op- that is not eliminated by hedging in the futures market. tion and futures contracts that do not require delivery of Bear: A trader or market analyst who feels that prices the underlying instrument. For options, the difference will decline. between the settlement price on the underlying asset and the option's exercise price is paid to the option holder at Bid price: The price at which buyers are willing to trade; exercise. For futures contracts, the exchange establishes usually accompanied by an ask—the price at which sell- a settlement price on the final day of trading and all ers will trade. The bid price is often a better indication remaining open positions are marked to market at that of the true market level. price.

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©International Monetary Fund. Not for Redistribution APPENDIX IV • GLOSSARY

CBOE: Chicago Board of Options Exchange. nancial intermediary such as a major money-center bank, an investment or merchant bank, or a securities company. CBT (also CBOT): Chicago Board of Trade. Counterparty risk: The risk that the other party to a CFTC: Commodity Futures Trading Commission, a U.S. contract will not fulfill the terms of the contract. It is federal regulatory agency that exercises control over fu- minimized through the clearinghouse system for ex- tures market trading in the United States. change-traded instruments, but is a relevant source of Clearinghouse: The branch of a futures exchange through risk for over-the-counter instruments such as forward which transactions executed on the floor are settled using agreements, interest rate caps, floors and collars, and a process of matching purchases and sales. A clearing interest rate or currency swaps. organization is also charged with the supervision of all Cover: To close out a position previously taken, usually trading accounts, the proper conduct of delivery proce- by buying to cover a previous short position. dures, and the adequate financing of the entire operation. CME: Chicago Mercantile Exchange. Covered writing: Generally refers to selling call options "covered" by an equal or larger long position in the COMEX: The Commodity Exchange. A New York ex- security underlying the option. It is a strategy intended change trading futures contracts on gold and silver and to augment overall returns by earning fee income on the option contracts on gold futures. options written against securities held for normal in- Commission: The broker's fee for executing a trade. In vestment purposes. the commodity market, commissions are round trip, en- Credit risk: Risk associated with the possibility that the titling the trader to buy and sell his contract. The fee is other party to a financial contract will be unwilling or paid only once after the initial position is closed out. unable to fulfill the terms of the contract. Credit risk is distinguished from the risks associated with changes in Commodity exchange: A nonprofit organization that prices, interest rates, or exchange rates (see also Coun- supervises and facilitates trading activity. terparty risk). Contango: See Carrying charge market. Cross-hedge: A hedge constructed using a hedging in- Contingent contract: Any contractual arrangement en- strument that differs in delivery date or other character- tered into at a particular point in time for the sale or istics from the existing exposure that is to be hedged. purchase of some asset or good at some point in the future Cross-hedging cannot eliminate all of the risk, but is contingent on a specificed event taking place. Futures effective in reducing it to the extent that the return on contracts, options, and other related instruments may the hedging instrument is correlated with the existing cash similarly be viewed as contingent contracts. exposure. Contract grades: Deliverable on a futures contract. Basic CSCE: Coffee, Sugar, and Cocoa Exchange, located in contract grade is the one deliverable at par. There may New York. be more than one basic grade. Currency swap: A transaction in which two counter- Contract month(s): The month(s) in which futures con- parties exchange specific amounts of two different cur- tracts may be satisfied by making or accepting a delivery. rencies at the outset and repay over time according to a predetermined schedule that reflects interest payments Conversion: An arbitrage strategy in options involving and, possibly, amortization of principal. The payment the purchase of the underlying instrument offset by the flows in currency swaps (in which payments are based establishment of a synthetic short position in options on on fixed interest rates in each currency) are generally like that instrument (the purchase of a put and sale of a call). those associated with a combination of spot and forward The overall position is unaffected by price movements currency transactions. in the underlying instrument. This trade would be estab- lished when small price discrepancies open up between Cylinder: An options position established by writing a the long position in the underlying instrument and the call option and buying a put option with a lower exercise synthetic short position in the options {see Arbitrage, price. Used as a hedging strategy to protect against the Reverse conversion, and Synthetic positions). eventuality that the price of the underlying instrument moves outside the range between the two exercise prices. Counterparty: The other party to a contract. For ex- change-traded futures and options contracts, the coun- Delivery: The three types of delivery on futures con- terparty is usually the exchange itself (an exception is tracts are "current"—delivery during the present month; LIFFE, where the broker plays this role). For over-the- "nearby"—delivery during the nearest active month; counter instruments, the counterparty is generally a fi- "distant"—delivery in a month further off.

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©International Monetary Fund. Not for Redistribution Glossary

Delivery date: Date on which the commodity must be Forward contract: A cash market transaction in which delivered to fulfill the terms of the contract. two parties agree to the purchase and sale of a commodity at some future time under such conditions as the two Delivery notice: The written notice given by the seller agree. In contrast to a futures contract, the terms of a of his intention to make delivery of a commodity to settle forward contract are not standardized; a forward contract a futures contract. This notice is passed on by the com- is not transferable and usually can be canceled only with modity exchange clearinghouse to a buyer who must ac- the consent of the other party, which often must be ob- cept delivery or retainer. tained for consideration and other penalty. Also, forward Delivery points: Locations designated by futures ex- contracts are not traded on organized exchanges. changes to which the commodity may be physically de- Forward rate agreement (FRA): An agreement be- livered. tween two parties wishing to protect themselves against Delivery price: Price fixed by clearinghouse at which a future movement in interest rates or exchange rates. In futures deliveries are invoiced. Also, price at which a an interest rate FRA, the two parties agree on an interest commodities futures contract is settled when deliveries rate for a specified period from a specified future settle- are made. ment date based on an agreed principal amount. No com- mitment is made by either party to lend or borrow the Delta: The change in an option's price associated with principal amount; their right (obligation) is only to receive a unit change in the price of the underlying instrument. (pay) the difference between the agreed and actual interest An option whose price changes by $1 for every $2 change rates at settlement. Similar agreements can be made with in the price of the underlying has a delta of 0.5. The respect to an exchange rate. delta rises toward 1.0 for options that are deep in-the- money, and approaches 0 for deep out-of-the money op- Forward-forward rate: A synthetic forward interest rate tions (see At-the-money, In-the-money, Out-of-the- constructed using the term structure of interest rates; see money, and Delta hedging). discussion in Appendix I. Delta hedging: A method used by option writers to hedge Futures contract: An exchange-traded contract gener- risk exposure of written options by purchase or sale of ally calling for delivery of a specified amount of a par- the underlying asset in proportion to the delta. For ex- ticular grade of commodity or financial instrument at a ample, a call option writer who has sold an option with fixed date in the future. Contracts are highly standardized a delta of 0.5 may engage in delta hedging by purchasing and traders need agree only on the price and number of an amount of the underlying instrument equal to one half contracts traded. Traders' positions are maintained at the of the amount of the underlying that must be delivered exchange's clearinghouse, which becomes a counterparty upon exercise. A delta-neutral position is established when to each trade once it has been cleared at the end of each the writer strictly delta hedges so as to leave the combined day's trading session. Members holding positions at the financial position in options and underlying instruments clearinghouse must post margin, which is marked to mar- unaffected by small changes in the price of the underlying ket daily. Most trades are unwound before delivery. The instrument. interposition of the clearinghouse facilitates the unwind- ing because a trader need not find his original counter- Delta-neutral: See Delta hedging. party, but may arrange an offsetting position with any trader on the exchange (see Margin). End-user: In contrast to an intermediary, a party that engages in a swap, cap, or other financial contract to Gamma: The sensitivity of an option's delta to small change its interest rate or currency exposure. End-users unit changes in the price of the underlying. Some option may be nonfinancial corporations, financial institutions, traders attempt to construct "gamma-neutral" positions or governments. in options (long and short) such that the delta of the overall position remains unchanged for small changes in European option: An option that may be exercised only the price of the underlying instrument. Using this method, on the expiration date. See American option. writers can produce a fairly constant delta and avoid the Exercise price (also strike price): The fixed price at transactions costs involved in purchasing and selling the which an option holder has the right to buy (in a call underlying instrument as its price changes (see Delta). option) or to sell (in a put option) the financial instrument Grantor: See Writer. covered by the option. Hedge ratio: The proportion of one asset required to Expiration date: (1) The date on which a European op- hedge against movements in the price of another. For tion may be exercised at the choice of the holder; and options, the hedge ratio is the proportion of the underlying (2) the date before or on which an American option may instrument needed to hedge a written option, and is de- be exercised. termined by the delta (see Delta and Delta hedging).

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©International Monetary Fund. Not for Redistribution APPENDIX IV • GLOSSARY

Hedging: The process of offsetting an existing risk by chant banks, and major Japanese securities companies. taking an opposite position on another risk likely to move Intrinsic value: The net benefit to be derived from ex- in the same direction. ercising an option contract immediately: the difference In-the-money: An option contract is in-the-money when between the price of the underlying instrument and the a net financial benefit could be derived by exercising the option's exercise price. An option generally sells for at option immediately (in comparison to throwing it away). least its intrinsic value (see also Time value). A call option is in-the-money when the price of the un- Inverted market (also backwardation): A market in derlying instrument is above the exercise price; a put which the cash market price is greater than the futures option is in-the-money when the price of the underlying market price: the opposite of a carrying charge market. instrument is below the exercise price. LIBOR: London interbank offered rate: the rate at which Initial margin: The funds that must be deposited to open banks offer to lend funds in the London interbank market. either a long or a short position in the futures market (see Margin). LIFFE: London International Financial Futures Ex- change. Interest rate cap: An option-like feature for which the buyer pays a fee or premium to obtain protection against Limit price (also maximum price fluctuation): Largest a rise in a particular interest rate above a certain level. permitted price fluctuation in a futures contract during a For example, an interest rate cap may cover a specified trading session, as fixed by the contract market's rules. principal amount of a loan over a designated time period such as a calendar quarter. If the covered interest rate Liquidity: The ease with which a prospective seller of rises above the rate ceiling, the seller of the rate cap pays a financial instrument can find a buyer at the prevailing the purchaser an amount of money equal to the average market price. Liquidity is generally higher in markets in rate differential times the principal amount times one which the volume of trading is larger. quarter. Log-normal distribution: A normal probability distri- Interest rate collar: An agreement that combines the bution of a variable expressed in logarithmic form. This purchase of an interest rate cap with the sale of a floor. distribution is often used for prices of assets or com- The purchaser of a collar receives a payment if the interest modities including the Black-Scholes model, because it rate rises above the designated ceiling, or makes a pay- implies that the price can rise to infinity but cannot fall ment if it falls below the designated floor. The purchase below zero (see Normal distribution). of a collar can be used to keep a debtor's net interest cost Long position: (1) In the futures market, the position within a pre-specified range. The premium on a collar is of a trader on the buying side of an open futures contract; lower than that on a cap with the same ceiling rate, and (2) in the options market, the position of a trader because the premium received by selling the floor is who has purchased an option regardless of whether it is subtracted from that paid for purchasing the cap. a put or a call. A participant with a long call option can profit from a rise in the price of the underlying instrument Interest rate floor: An option-like agreement whereby while a trader with a long put option can profit from a the buyer pays a premium to obtain protection against a fall in the price of the underlying instrument. fall in a particular interest rate below a certain level. If the interest rate falls below the floor, the seller pays the Maintenance margin: The minimum amount that must purchaser an amount equal to the average rate differential remain in the margin account after any market losses are times the principal amount times the designated time deducted from the initial margin. Once the account de- period. clines to the maintenance level, the broker will issue a Interest rate swap: A transaction in which two coun- margin call—a request that the client restore the account terparties exchange interest payment streams of differing to its original level. Should the client refuse or default, character based on an underlying notional principal amount. the position may be closed out by the broker. The three main types are coupon swaps (fixed rate to Margin: An amount of money deposited by both buyers floating rate in the same currency), basis swaps (one and sellers for futures contracts to ensure performance floating rate index to another floating rate index in the of the terms of the contract, that is, the delivery or taking same currency), and cross-currency interest rate swaps of delivery of the commodity or the cancellation of the (fixed rate in one currency to floating rate in another). position by a subsequent offsetting trade at such price as Intermediary: A counterparty who enters into swap, can be attained. Margin in futures markets is not a pay- cap, forward, or other over-the-counter contracts to earn ment of equity or down payment on the commodity itself fees or trading profits. Most intermediaries, or dealers, but is rather in the nature of a performance bond or in these over-the-counter markets are major U.S. money- security deposit (see Initial margin and Maintenance center banks, major U.S. and U.K. investment and mer- margin).

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©International Monetary Fund. Not for Redistribution Glossary

Margin call: A commodity broker's request to a client transactions among market-makers and between market- for additional funds to secure the original deposits (see makers and their customers. Firms mutually determine also Variation margin). their trading partners on a bilateral basis. Minimum price fluctuation: Set by the rules of the Out-of-the-money: An option contract is out-of-the- exchange, the minimum unit by which the price of a money when there is no benefit to be delivered from commodity can fluctuate per trade. exercising the option immediately; a call option is out- of-the-money when the price of the underlying instrument Mirror swap: A reverse swap written with the original is below the option's exercise price; a put option is out- counterparty. of-the-money when the price of the underlying instrument Naked writers: See Uncovered writers. is above the option's exercise price. Normal distribution: "Bell-shaped" curve depicting a PHLX: Philadelphia Stock Exchange. symmetric probability distribution of a continuous ran- Pit: Where futures are traded on the floor of the com- dom variable. The distribution is defined by the mean modity exchange. and standard deviation, such that approximately two thirds of all observations will fall within one standard deviation Plain-vanilla swap: A U.S. dollar interest rate swap in above and below the mean, about 95 percent will fall which one party makes floating rate payments based on within two standard deviations above and below the mean, the six-month LIBOR and receives fixed rate funds ex- and so on. pressed as a spread over the rate on U.S. Treasury se- curities. The maturity is usually five to seven years and Normal market: See Carrying charge market. deal size is normally at least $50-100 million. Notional principal: A hypothetical amount on which Position: A market commitment. For example, one who swap payments are based. The notional principal in an has bought futures contracts is said to have a long po- interest rate swap is never paid or received. sition, and, conversely, a seller of futures contracts is Off-balance-sheet activities: Banks' business, often fee- said to have a short position. based, that does not generally involve booking assets and Position limit: The maximum number of speculative fu- taking deposits (for example, trading of swaps, options, tures contracts one can hold as determined by the CFTC foreign exchange forwards, stand-by commitments, and and/or the exchange upon which the contract is traded. letters of credit). Premium: The price paid for an option by an option Open interest: The total number of futures contracts of holder to the option writer. a given commodity that have not yet been offset by op- posite futures transactions nor fulfilled by delivery of the Put option: See Option. commodity: the total number of open transactions. Each Reporting limit, reportable position: The number of open transaction has a buyer and a seller, but for cal- futures contracts, as determined by the exchange and/or culation of open interest, only one side of the contract the CFTC, above which one must report daily to the is counted. exchange and/or the CFTC with regard to the size of Open outcry: Trading conducted by calling out bids and one's position by commodity, by delivery month, and by offers across a pit and having them accepted. purpose of the trading. Option: The contractual right, but not the obligation, to Reverse conversion: An arbitrage trade in options in- buy or sell a specified amount of a given financial in- volving the sale of the underlying instrument and the strument at a fixed price before or at a designated future establishment of a synthetic long position in options on date. A call option confers on the holder the right to buy the underlying instrument (the purchase of a call and sale the financial instrument. A put option involves the right of a put) (see Arbitrage, Conversion, and Synthetic to sell the financial instrument. position). OCC: Options Clearing Corporation—a corporation that Reverse swap: One form of activity in the secondary provides clearing facilities for all option trades on U.S. swap market. A reverse swap offsets the interest rate or securities exchanges. currency exposure on an existing swap. It can be written with the original counterparty or with a new counterparty, OTC market (over-the-counter market): Trading in but, in either case, usually executed to realize capital financial instruments transacted off organized exchanges. gains. Generally the parties must negotiate all details of the transactions or agree to certain simplifying market con- Rollover: The replacement of one futures market posi- ventions. In most cases, OTC market transactions are tion with another in the same commodity, but in a dif- negotiated over the telephone. OTC trading includes ferent delivery month.

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©International Monetary Fund. Not for Redistribution APPENDIX IV • GLOSSARY

Round trip: See Round turn. Straddle: An options position established by the pur- chase of a put and a call with the same exercise price Round turn (also Round trip): A futures contract pur- and expiration date. This position is designed to profit chase followed by an offsetting sale before delivery, or from an increase in the price volatility of the underlying a sale followed by an offsetting purchase. instrument. Settlement price: The price of the financial instrument Strike price: See Exercise price. underlying the option contract at the time the contract is exercised. Where necessary, option contracts specify ob- Strip: (1) A futures position established by taking the jective standards for determining the settlement price. same (long or short) position in a futures contract for a series of delivery dates. This strategy may be used to Settlement risk: The possibility that operational diffi- hedge risk associated with a series of payments or re- culties interrupt delivery of funds even where the coun- ceipts; and (2) an options straddle position consisting of terparty is able to perform. the purchase of more puts than calls although all have Short position: (1) In the futures market, the position the same exercise date and exercise price. While the of a trader on the selling side of an open futures contract; trader expects an increase in price volatility, there is also and (2) in the options market, the position of a trader the expectation that the price of the underlying instrument who has sold or written an option regardless of whether is more likely to fall than to rise. it is a put or a call. The writer's maximum potential profit Strip yield curve: A synthetic yield curve implied by is the premium received. the structure of futures prices; see discussion in Appendix I. Speculator: In an economic sense, one who attempts to Swap: A financial transaction in which two counterpar- anticipate commodity price changes and to profit through ties agree to exchange streams of payments over time the sale and purchase or purchase and sale of commodity according to a predetermined rule. A swap is normally futures contracts or of the physical commodity; in a legal used to transform the market exposure associated with a sense, any commodity futures trader not classified as a loan or bond borrowing from one interest rate base (fixed bona fide hedger by the CFTC. term or floating rate) or currency of denomination to Spot: Term denoting immediate delivery for cash as dis- another (see Currency swaps and Interest rate swaps). tinct from future delivery. Synthetic positions: Combinations of options and/or the Spread: (1) A futures position established by simulta- underlying instrument to produce artificially a desired neous purchase of one commodity futures contract(s) and risk/gain position which corresponds to that associated sale of another contract(s) in a different delivery month, with another asset which may or may not be directly in a different commodity, or traded on a different ex- obtainable. Some examples of synthetic positions are change; and (2) an options position established by si- (1) synthetic long call: purchase put and purchase the multaneously purchasing an option and writing another underlying instrument; (2) synthetic long put: purchase with a different exercise price or expiration date. When call and sell the underlying instrument; (3) synthetic long exercise prices differ, the position is called a bull or bear position in the underlying instrument: purchase call and spread; when expiration dates differ, a calendar spread. sell put with same strike price and same exercise date; and (4) synthetic short position in the underlying instru- Stack hedge: A futures hedging strategy that involves ment: sell call and purchase put with same strike price taking a large position in an existing contract and sub- and same exercise date. sequently rolling over part of this position into a later contract month, possibly repeating this procedure several Thin market: A low-volume market in which a large times. This strategy may be used to hedge risks associated trade unduly affects the market price (see Volume; Liq- with a series of payments or receipts, particularly where uidity). these are to occur at dates for which futures contracts are nonexistent or illiquid {see also Strip; Liquidity). Time value: The imputed monetary value of an option reflecting the possibility that the price of the underlying Standard deviation: A statistical measure of the dis- instrument will move so that the option will become more persion of observations on a variable. Specifically, it is valuable. The total value of an option, or its price, is equal to: comprised of its intrinsic value and its time value.

2 Trading limit: The maximum number of contracts, as \ln [Xt - X] determined by an exchange and/or the CFTC, that one may trade in a given trading day. where Xt are the n individual observations on a variable, X is the mean (or average) observation, and n is the total Uncovered writers (also naked writers): Option sellers number of observations. who do not attempt to reduce their market risk by taking

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©International Monetary Fund. Not for Redistribution Glossary offsetting positions in the underlying security or other deviation in the logarithm of the price of the underlying options. Also called taking a "biased" view in option instrument expressed at an annual rate. Expected vola- writing, that is, anticipating that the option will fall in tility is a variable used in pricing options (see Standard value. deviation).

Underlying instrument: The designated financial in- Volume: The number of transactions in a financial in- strument that must be delivered in completion of an op- strument made during a specified period of time. tion contract or a futures contract (for example, fixed- income securities, foreign exchange, equities, or futures Voluntary termination (swap market): The cancella- contracts (in the case of futures option)). tion of a swap contract which is agreed to by both coun- terparties; usually involves a lump-sum payment from Variation margin: Margin that must be posted to restore one party to the other. a futures account to the maintenance level (see also Maintenance margin). Writer (also Grantor): The party that sells an option. Volatility: The price "variability" of the instrument un- The writer is required to carry out the terms of the option derlying an option contract, and defined as the standard at the choice of the holder.

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©International Monetary Fund. Not for Redistribution Bibliography

Andersen, Torben Juul, Currency and Interest Rate Hedging: Giddy, Ian H., "Why It Doesn't Pay to Make a Habit of A User's Guide to Options, Futures, Swaps, and Forward Forward Hedging," Euromoney (London) (December 1976), Contracts (New York: New York Institute of Finance, pp. 96-100. 1987). Hammonds, T.M., The Commodity Futures Market from an Bank for International Settlements, Recent Innovations in In- Agricultural Producer's Point of View (New York: MSS ternational Banking, prepared by a study group established Information Corporation, 1972). by the central banks of the Group of Ten (Basle: Bank International Chamber of Commerce, Futures and Options for International Settlements, April 1986). Trading in Commodity Markets (Paris: International Black, Fischer, "The Pricing of Commodity Contracts," Jour- Chamber of Commerce, 1986). nal of Financial Economics, Vol. 3 (1976), pp. 167-79. International Monetary Fund, Primary Commodities: Market , and Myron Scholes, "The Pricing of Options and Developments and Outlook by the Commodities Division Corporate Liabilities," Journal of Political Economy of the Research Department (Washington: International (Chicago), Vol. 81 (May-June 1973), pp. 637-54. Monetary Fund, May 1988). Bond, Marion, and Elizabeth Milne, "Export Diversification Jarrow, Robert A., and Andrew Rudd, Option Pricing (Home- in Developing Countries: Recent Trends and Policy Im- wood, Illinois: Dow Jones-Irwin, 1983). pact," in Staff Studies for the World Economic Outlook Kohlhagen, Steve, "Evidence on the Cost of Forward Cover by the Research Department of the International Monetary in a Floating System," Euromoney (London) (September Fund (Washington: International Monetary Fund, August 1985), pp. 138-41. 1987). Labys, Walter C., and Peter K. Pollak, Commodity Models for Boughton, James M., and William H. Branson, "Commodity Forecasting and Policy Analysis (New York: Nichols Pub. Prices as a Leading Indicator of Inflation," IMF Working Co., 1984). Paper, No. 87 (mimeographed, International Monetary Lessard, Donald R., ed., International Financial Management: Fund, October 3, 1988). Theory and Application (New York: Wiley, 2nd ed., 1985), Brignoli, Richard, and Lester Seigel, "The Role of Noise in chaps. 17-21. LDC Growth,'' paper presented at Roundtable Conference Loosigian, Allan M., Interest Rate Futures (Princeton, New on Trends in International Capital Markets: Implications Jersey: Dow Jones Books, 1980). for Developing Countries (February 1988). McKinnon, Ronald I., "Futures Markets, Buffer Stocks and Buckley, John, ed., Guide to World Commodity Markets: Phys- Income Stability for Primary Producers," Journal of Po- ical, Futures and Options Trading (London: Kogan Page, litical Economy, Vol. 75, No. 6 (December 1967), pp. 5th ed., 1986). 844-61. Coninx, Raymond G.F., Foreign Exchange Dealer's Hand- Mitchell, Mark H., and others, "Regulation of the Futures book (Cambridge, England: Woodhead-Faulkner, 2nd ed., Industry," in The Concise Handbook of Futures Markets, 1986). ed. by Perry J. Kaufman (New York: Wiley, 1986), chap. 5. Fitzgerald, M. Desmond, Financial Options (London: Euro- Peck, Anne E., "Futures Markets, Food Imports and Food money Publications, 1987). Security," AGREP Division Working Paper, No. 43 Folkerts-Landau, David, "Marked-to-Market Interest Rate (Washington: World Bank, September 1982). Swaps: A Solution to the Interest Rate Risk Management Powers, Mark J., and Paula Tosini, "Commodity Futures Ex- Problem of Indebted Developing Countries," in Analytical changes and the North-South Dialogue," American Jour- Issues in Debt, ed. by Jacob A. Frenkel (Washington: nal of Agricultural Economics (St. Paul, Minnesota), Vol. International Monetary Fund, forthcoming 1989). 59 (December 1977), pp. 977-85. Gardner, Bruce L., "Commodity Options for Agriculture," Rolfo, Jacques, "Optimal Hedging Under Price and Quantity American Journal of Agricultural Economics (St. Paul, Uncertainty: The Case of a Cocoa Producer," Journal of Minnesota), Vol. 59 (December 1977), pp. 986-92. Political Economy (Chicago), Vol. 88 (February 1980), pp. 100-116. Gemmill, Gordon, "Optimal Hedging on Futures Markets for Sutton, William, The Currency Options Handbook (Cam- Commodity-Exporting Nations," European Economic bridge, England: Woodhead-Faulkner, 1988). Review (Amsterdam), Vol. 27 (March 1985), pp. 243-61. Thompson, S., "The Use of Futures Markets by Less Devel- , and Desmond Fitzgerald, Hedging Techniques (Lon- oped Countries for Commodity Exporting," AGREP Di- don: London International Financial Futures Exchange Ltd., vision Working Paper, No. 65 (Washington: World Bank, 1982). March 1983).

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, "Use of Futures Markets for Exports by Less De- Journal of Agricultural Economics (St. Paul, Minnesota), veloped Countries," American Journal of Agricultural Vol. 67 (December 1985), pp. 980-85. Economics (St. Paul, Minnesota), Vol. 67 (December 1985), pp. 986-91. Watson, Maxwell, and others, International Capital Markets: Thompson, Stanley R., and Gary E. Bond, "Basis and Ex- Developments and Prospects, 1987 (Washington: Inter- change Rate Risk in Offshore Futures Trading,'' American national Monetary Fund, 1987).

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