Re: Greenspan' and Derivatives

["Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>]

They are not MY descriptions.  They are industry standard descriptions.
 In the 1940s, neither concept was in existence as they are used now in
structured finance.  Workinng's view on hedging was published in 1962,
not in 1940s.

The two classic Holbrook Working books:

Futures Trading and Hedging
New Concepts Concerning Futures Markets and Prices

did not conclude what you represented.

"Perhaps his (Working's)greater claim to fame is in the theory of
finance where he advanced theories on futures markets and hedging. In
particular, Working challenged Keynes's (1923, 1930) view that hedgers
on futures markets paid a risk premium to speculators in order to divest
themselves of all risk. Working (1953, 1962) claimed that hedgers still
bear risk - but of a different type, namely quantity risk. Thus hedging,
in Working's view, was merely a way of arbitraging between two markets -
the spot and the futures."
http://cepa.newschool.edu/het/profiles/working.htm

One of the great debates in the futures market literature is that
between Keynes with his theory of "Normal Backwardation," which implies
that futures prices are biased estimates of future spot prices, and
Holbrook Working who argued that with the proper accounting of carrying
charges that futures prices are unbiased estimates of future spot prices.

 There is no such thing as a perfect hedge. You can never completely
eliminate a cash position's risk. Consider a holder of Q Treasury bonds
maturing in 2004 with a coupon rate of 8%. Assume that the holder of
bonds believes that bond prices are going to fall. To hedge his risk,
the person shorts an equivalent amount of futures contracts for Treasury
bonds. At a later date, the person will close out both its bond and
futures positions. At the close, the firm will receive B_T per bond sold
in the regular  spot or  cash market. The futures price is F_0 at the
time the futures are sold short, and its price at the closeout is F_T.
Prior to the closeout, both B_T and F_T are uncertain, although F_0 is
known. The usual computation of the funds that the person will have at
closeout is:

Net Revenue(bond sale plus futures) = Q[B_T + (F_T - F_0)] =QF_0 + Q[B_T
- F_T]

From the above equation, the net revenue from the hedge position is
composed of (1) a certain component that depends upon the futures price
at the time of the hedge (F_0) and (2) an uncertain component that
depends upon the difference between the price received for bonds in the
spot market and the futures price at closeout (B_T-F_T). The difference
between the spot and the futures price is called the basis. Thus,
uncertainty about the net hedged revenue arises if there is uncertainty
about the basis. To quote Holbrook Working, "hedging is speculation in
the basis".

There are many reasons for the basis to be uncertain.

    * First, the good or instrument being hedged may be different from
the good or instrument for which there is a futures contract. This would
be the case if a corporate bond offering is hedged with Treasury bond
futures; basis risk arises due to the uncertainty of the yield
differential at the time the hedge is lifted.
    * Second, in commodity futures, there is basis risk due to
locational differentials. For example, a cattle farmer in Texas who
hedges with a cattle futures contract that calls for delivery in Omaha
has the uncertainty of the closeout differential between the Texas steer
price and the Omaha steer price. This is called locational basis risk.
This is usually an important factor in agricultural contracts. The risk
is compounded by the fact that the seller usually has the option of
where delivery is made.
    * The third type of basis risk arises because the seller of the
futures contract often has the option to choose the quality of the goods
or financial instrument delivered. For example, the Treasury bond
futures market calls for delivery of any U.S. Treasury bond that is not
callable within 15 years. Since there are many instruments that are
candidates for delivery, the hedge has the risk of fluctuations in the
yield spread between the instrument hedged and the instrument ultimately
delivered.
    * Fourthly, with most futures contracts, the seller has the choice
of the date of delivery within the delivery month. This choice is an
uncertain value and thus contributes to basis risk.
* Finally, the mark to market aspect of futures results in hedging risk.
The uncertainty is about the amount of interest earned or forfeited due
to the daily transfers of profits and losses. In fact, the equations for
net revenue are not exactly right due to the omission of interest earned
(lost) on futures profits (losses).

http://www.duke.edu/~charvey/Classes/ba350/futures/futures.htm


The hedging plays that Working was referring was a different animal than
the hedging plays of today.

The underlying function of a hedge is protection. It buys protection by
giving away potential profit.  The fact that complete protection is
rarely buyable does not change the underlying function.

The underlying function of arbitrage is quest for profit. It tries to
profit without risk by the expectation of mispricing between two linked
instruments to return to equilbrium.  The fact that a risk free
arbitrage does not exist does not change the underlying function.

Any trader who thinks the two are indistinguishable will not survive for
long.

For corporations or trading organizations with energy/commodity
exposures, the question of what risks to hedge and exactly how to hedge
them is fundamental to corporate strategy. The Metallgesellschaft
debacle, with which I am very familiar from personal experience as an
advisor to a counterparty, was a classic example of a ruinous confusion
between arbitrage and hedging on the part of MG.

Timing has a lot to do with applicability.  In the same year that Merton
published his article on option pricing theory (1973), the Chicago Board
Options Exchange opened and provided the perfect testing ground for the
practical implementation of the Black-Scholes model. Within six months
of the original publication of the Black-Scholes formula, it had become
so widely used by traders at the CBOE that Texas Instruments produced a
handheld calculator pre-programmed to produce Black-Scholes option
prices and hedge ratios.  B/S became a self fufilling phenomenon and an
industry standard, just like Bill Gate's DOS/Windows.  Otherwise, B/S
would still be just another obscure theory.

Henry C.K. Liu

Stan Jonas wrote:
> Actually since the work of Holbrook Working circa 1940's analytically we've
> known
> that arbitrage and "hedging" as you describe it are indistinguishable..
>
> Why hedge.. if you think someting is going to go down.. sell it....get out..
> Only rationale to "hedge" is that you think you can structure a defacto
> positive
> expected value arbitrage"...
>
>
> ----- Original Message -----
> From: "Henry C.K. Liu" <hliu@xxxxxxxxxxxxxx>
> To: <pkt@xxxxxxxxxxxxxxxx>
> Sent: Saturday, March 15, 2003 1:16 PM
> Subject: Re: Greenspan' and Derivatives
>
>
>
> > Arbitrage is not the same as hedging:
> >
> > Arbitrage: Simultaneous purchase and sale of two different contracts (or
> > a combination of cash and futures) to take advantage of perceived
> > mispricing. In a pure arbitrage, mispricing is locked in and a risk-free
> > profit made through trades.
> >
> > Hedge: A sale of futures contracts to offset the ownership or purchase
> > of the underlying cash commodity in order to protect it against adverse
> > price moves; or, conversely, a purchase of futures contracts to offset
> > the sale of the underlying cash commodity, again for protection against
> > adverse price moves.