FUTURES AND FORWARDS

• Forward and futures contracts are agreements to sell an asset at a fixed price on a fixed date in the future. Futures are traded on a wide range of agricultural products (including wheat, maize, soybeans, pork, beef, sugar, tea, coffee, cocoa and orange juice), industrial metals (aluminium, copper, lead, nickel and zinc), precious metals (gold, silver, platinum and palladium) and oil. These products are known as commodities. Futures were invented to enable regular buyers and sellers of commodities to protect themselves against losses or to hedge against future changes in the price. If they both agree to hedge, the seller (e.g. an orange grower) is protected from a fall in price and the buyer (e.g. an orange juice manufacturer) is protected from a rise in price.
  • Futures are standardized contracts – contracts which are for fixed quantities (such as one ton of copper or 100 ounces of gold) and fixed time periods (normally three, six, or nine months) – that are traded on a special exchange.
  • Forwards are individual, non-standardized contracts between two parties, traded over-the-counter – directly, between two companies or financial institutions, rather than through an exchange. The futures price for a commodity is normally higher than its spot price – the price that would be paid for immediate delivery. Sometimes, however, short-term demand pushes the spot price above the future price. This is called backwardation.

• Futures and forwards are also used by speculator – people who hope to profit from price changes.
• More recently financial futures habe been developed. These are standardized contracts, traded on exchanges, to buy and sell financial assets. Financial assets such as currencies, interest rates, stocks and stock market indexes fluctuate – continuously vary – so financial futures are used to fix a value for a specified future date (e.g sell euros for dollars at a rate of 1EUR for 1.20 USD on June 30).
• Currency futures and forwards are contracts that specify the price at which a certain currency will be thought or sold on a specified date.
• Interest rate futures are agreements between banks and investors and companies to issue fixed income securities (bonds, certificates of deposit, money market deposits, etc.) at a future date.
• Stock futures fix a price for a stock and stock index futures fix a value for an index (e.g. the Dow Jones or the FTSE) on a certain date. They are alternatives to buying the stocks or shares themselves.
• Like futures for physical commodities, financial futures can be used both to hedge and to speculate. Obviously, the buyer and seller of a financial future have different opinions about what will happen to exchange rates, interest rates and stock prices. They are both taking an unlimited risk, because there could be huge changes in rates and prices during the period of the contract. Futures trading is a zero-sum game, because the amount of money gained by one party will be the same as the sum lost by the other.

DERIVATIVES

• Derivatives are financial products whose value depends on – or is derived from – another financial producer, such as a stock, a stock market index, or interest rate payments. They can be used to manage the risks associated with securities, to protect against fluctuations in value, or to speculate. The main kinds of derivatives are options and swaps.
• Options are like futures except that they give the right – gave the possibility, but not the obligation – to buy or sell an asset in the future (e.g. 1000 General Electric stocks on 31 March). If you buy a call option, it gives you the right to buy an asset for a specific price, either at any time before the option ends on a specific price within a specified period or on a specific future date. Investors can buy put options to hedge against falls in the price of stocks.
• Selling or writing options contract involves the obligation either to deliever or to buy assets, if the buyer exercises the option – chooses to make the trade. For this the seller (writer) receives a fee called a premium from the buyer. But writers of opinions do not expect them to be exercised. For example, if you expect the price of a stock to rise from 100 to 120, you can buy a call option giving the right to buy the stock at 110. If the stock price does not rise to 110, you will not exercise the option, and the seller of the option will gain the premium. Your option will be out-of-the-money, as the stock is trading at below the strike price or exercise price of 110, the price stated in the option. If, on the other hand, the stock price rises above 110, you are in-the-money: you can exercise the option and you will gain the difference between the current market price and 110. If the market moves in an unexpected direction, the writers of options can lose enormous amounts of money.

 Video 1: Call option

• Some companies issue warrants, which, like options, give the right, but not the obligation, to buy stocks in the future at a particular price, probably higher than the current market price. They are usually issued along with bonds, but they can generally be detached from the bonds and traded separately. Unlike call options, which last three, six or nine months, warrants have long maturities of up to ten years.
• Swaps are arrangements between institutions to exchange interest rates or currencies (e.g. dollars for yen). For example, a company that has borrowed money by issuing floating-rate notes could protect itself from a rise in interest rates by arranging with a bank to swap its floating-rate payments for a fixed-rate payment, if the bank expected interest rates to fall.

ASSET MANAGEMENT

• Asset management is managing financial assets for institutions or individuals.
  • Pension funds and insurance companies manage huge amounts of money.
  • Private banks specialise in managing portfolios of wealthy individuals.
  • Unit trusts invest money for small investors in a range of securities.
• Asset managers have to decide how to allocate funds they’re responsible for; how much to invest in shares, mutual funds, bonds, cash, foreign currencies, precious metals, or other types of investments.
• Asset allocation decisions depend on objectives and size of the portfolio. The portfolio’s objectives determine the returns’ expected or needed, and the acceptable level of risk. The best way to reduce exposure to risk is to diversify the portfolio – easier and cheaper for a large portfolio than a small one.
• Investors have different goals or objectives:
  • Some want regular income from the investments – less concerned with size of their capital.
  • Some want to preserve (keep) their capital – avoiding risks. If the goal is capital preservation, the asset manager usually allocates more money to bonds than stocks.
  • Others want to accumulate or build up capital – taking more risks. If the goal is growth or capital accumulation, the portfolio will probably include more shares than bonds. Shares have better profit potential than bonds, but are also more volatile – their value can increase or decrease more in a short period of time.
  • Some asset managers (or their clients) choose an active strategy – buying and selling frequently, adapting the portfolio to changing market circumstances.
  • Others use a passive strategy – buying and holding securities, leaving the position unchanged for a long time.
• Nowadays, there are a lots of index-linked funds which simply try to track or follow the movements of a stock market index. They buy lots of different stocks in the index, so if the index goes up or down, the value of the fund will too. They change much lower fees than actively managed accounts – and usually do just as well. Investors in these funds believe that you can’t regularly outperform the market – make more than average returns from the market.

HEDGE FUNDS

• Hedge funds are private investment funds for wealthy investors, run by partners who have made big personal investments in the fund. They pool or put together their money and investors’ money and trade in securities and derivatives, and try to get high returns whether markets move up or down. They are able to make big profits, but also big losses if things go wrong. Despite their name, hedge funds do not necessarily use hedging techniques – protecting themselves against future price changes. In fact, they generally specialise in high-risk, short-term speculation on stock options, bonds, currencies and derivatives. Because they are private, hedge funds do not have to follow as many rules as mutual funds.
• Most hedge funds use gearing or leverage, which means borrowing money as well as using their own funds, to increase the amount of capital available for investment. In this way, the fund can hold much larger positions or investments. Hedge funds invest where they see opportunities to make short-term profit, generally using a wide range of derivative contracts such as options and swaps. They take a long position by buying securities that they believe will increase in value, but which they have not yet purchased. This is called taking a short position. If the price does fall, they can buy them at a lower price, and sell them at a profit.
• Hedge funds also use arbitrage, which means simultaneously purchasing a security or currency in one market and selling it, or a related derivative product, in another market, at a slightly higher price. In this way, investors can profit from price difference between the two markets. Because the price difference is usually very small and would be zero if markets were perfectly efficient), a hige volume is required for the arbitrageur to make a significant profit.
• Investors who do not have sufficient funds to join a hedge fund can buy structured products from banks. These are customized – individualized or non-standard – over-the-counter financial instruments. They use derivative products (futures, forwards, options, warrants, etc.) in a way similar to hedge funds, depending ont the customer’s requirements and changes in the markets.

 Video 2: Hedge funds

Treasury function of companies

• Some companies opt to “make money from money.” This means they use their cash assets not only to further the development of their products, but also to generate money through the financial markets. Some companies believe that by making hedges (bets) on the fluctuations of the currency markets, for example, they can gain access to a new source of profit. The two terms that exemplify the idea of making money from money are “treasury function” and ”shadow banks.”
• “Treasury function” is a term that emerged in the late 1970s in the wake of economic challenges, such as quadrupled oil prices and “stagflation” (where inflation and unemployment are both high at the same time). The idea emerged that the goal of a company’s treasury function (the department responsible for stewarding its finances) should be to achieve the optimum balance between liquidity and income from the company’s cash flows. During the decades leading up to the 2007–08 financial crisis, large companies steadily added greater responsibilities to the treasury function. Often, these began as ways to minimize risk, but the opportunities for profitable trading became very tempting—to the point that some companies took out contracts on financial hedges that were worth more than all their export earnings.

Case study: Aracruz: In 2008, the Brazilian paper and pulp company Aracruz used cash assets to make bets on currency futures (the value of currencies at a future date). Specifically, it bet that the Brazilian currency would continue to rise, but in fact it underwent a sharp devaluation and the company ended up losing $2.5 billion. As a result, some companies now spell out their opposition to making money from money. Mining multinational Rio Tinto, for example, stated in its 2013 annual report that its treasury “operates as a service to the businesses of the Rio Tinto group and not as a profit center.”

• Other companies, however, have extended the treasury function to become a major, or even majority, profit center for the business.

Case study: GE Capital: Companies such as US conglomerate General Electric (GE) have developed this function into an effective “shadow bank.”  In 2007, GE’s treasury function GE Capital held over $550 billon of assets, making it larger than some of America’s top ten banks. It contributed 55 percent of GE’s profits, mainly by borrowing money short-term to lend to customers over the long-term (“borrowing short and lending long”). GE was able to flourish as a member of the shadow banking system without having to bear the regulatory burdens of banks. By 2008, however, it was forced to ask to participate in the US government’s banking sector bail-out program. Making money from money carries serious risks, whether the bets go wrong or not. This is because the more profits a company’s treasury generates, the less willing the board may be to invest in research and development for the future growth of the company. This way of making money from money is strongly correlated with short-termism in business.

Takeoververs and leverage: 

• A series of takeovers can result in a parent company controlling a number of subsidiaries: smaller companies that it owns. When the subsidiaries operate in many different business areas, the company is known as a conglomerate.
• But large conglomerates can become inefficient. Top executives often leave after hostile takeovers, and too much diversification means the company is no longer concentrating on its core business: its central and most important activity. Takeovers do not always result in synergy: combined production or productivity that is greater than the sum of the separate parts. In fact, statistics show that most mergers and acquistions reduce rather than increase a company’s value.
• An inefficient conglomerate whose profits are too low can have a low stock price and its market capitalization – the total market price of all its ordinary shares – cann fall below the value of its assets, including land, buildings and pension funds. If this happens, it becomes profitable for another company to buy the conglomerate and either split it up and sell it as individual companies, or close the companies and sell the assets. This pracrice, common in the USA but rare in Europe and Asia, is called asset-stripping. It shows that stock markets are not always efficient and that companies can sometimes be undervalued or underpriced: the price of their shares on the stock market can be too low. Some people argue that asset-stripping is a good way of using capital more efficient; others argue that it is an unfortunate activity that destroys companies and jobs.
• If corporate raiders – individuals or companies that want to take over other companies – borrow money to do so, usually issuing bonds, the takeover is called a leveraged buyout (or LBO). Leveraged means largely financed by borrowed capital. After the takeover, the raider sells subsidiaries of the company in order to pay back the bondholders.
• Bonds issued to pay for takeovers are usually called junk bonds – because they are risky: it may not be possible to sell the subsidiaries at a profit. But, because of the risk, these bonds pay a high interest rate, so some investors are happy to buy them.
• Sometimes a company’s own managers want to buy the company, and re-organize it. This a management buyout or MBO. If the buyout is financed by issuing preference shares and convertibles, this is called mezzanine financing as it is, in a sense, halfway between debt and enquiry.

  Video 3: Mezzanine financing

 Video 4: Arbitrage

Discuss the following negotiation techniques in relation to the movie!

1. Don’t be needy.
2. Be prepared for the adversary’s no-shows.
3. Realize that adversarial no-shows are often a ploy.
4. Expect an apology for a no-show or cancellation.