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the idiots guide to hedging and derivatives - very

  1. noip

    165 Posts.

    Just read this on Minelab, regards noip

    Ismail is a successful mule trader in Peshawar. Every year Ismail delivers 30 mules to the Kabul Mule Market and gets $40 per mule. This year however, the Khyber Pass is full of warlord militias, so Ismail is not sure he can drive his mules to market without losing a mule here and there. Also, the demand for mules in Kabul seems to be dropping. Maybe he'll only be able to sell 20 mules, or, God forbid, 15, and then be forced to feed and water the rest of them on a money-losing trek back home. In other words, it's a scary market and Ismail is worried about feeding his family. What Ismail needs is to limit his risk with an Enron derivatives package.
    First he pays $2 per mule for a Khyber Pass Derivative, so that any mule killed or stolen by warlords will be reimbursed at the rate of $20 per mule -- half the going market rate, but still better than taking a total loss. Next he sells Enron Mule Futures. For $28 per contract, he guarantees delivery of a mule in three months time. He sells 15 of these, figuring that a guaranteed $28 mule sale is better than showing up in Kabul and discovering that the mule buyers have been killed by stray bombs.

    Meanwhile, at the Enron Mule Trading Desk in Houston, eagle-eyed yuppies are studying the worldwide mule markets and starting to have their doubts about those $28 delivery contracts. Mule use is dropping all over Afghanistan, even as the mule count is dwindling. Better resell eight of those 15 contracts to a European commodities broker for $24 each, then make up that $32 loss somewhere else while cutting the company's exposure in half. But how to hedge the risk on the other seven?

    Aha! A blip on the computer screen. A temporary mule shortage in southern Iran! With a current mule price of $42 in Tehran, Enron could offer a Linked Mule Swap Double Derivative tied to the gap between the price of mules delivered in Kabul on a given date and the price in Tehran on the same date. Sure, you would rather have the quick-and-clean Iran sale, instead of the sale in Kabul that requires trucking the mules to a foreign market. But even if you add in $4 per mule for transport through militia-held territory and averaged the markets together, you can still clear eight bucks just on the gap alone.

    Enron's average price-per-future-mule is now $32.57 when you include the $4-per-mule loss on the mule futures dumped in Europe. But based on the amazing $12 Kabul/Tehran trading gap, they can easily put together a "delivery in either market" contract that will allow them to ask $36 per mule on their Mule Online Internet trading system.

    The first mule future sells instantly for $36, and the price bobs up to $36.50. Two mules go for $36.75, and then there's a big jump for the last three mules to $37.90. Enron has now off-loaded all its price-based mule futures liability for a profit of $31.70. But this doesn't mean they're out of the mule market in Central Asia. It's still two months until Ismail delivers his 30 mules, and Enron is on the hook for his Khyber Pass derivative insurance policy. Things are not looking good in that part of the world, either. The chances of a mule being picked off as a road-passage tax are pretty high, and the loss of the whole herd would be a $600 liability.

    Quickly, the financial boys go to work, and part of that liability is resold to a consortium of Singapore banks, Australian mutual funds, and Saudi Arabian arms merchant Adnan Kashoggi, thereby reducing Enron's percentage to 25%, or $150 in potential liability against a $15 premium (remember the $2 per mule paid by Ismail), and Enron also takes a brokerage fee of $20 from the three other partners, thereby reducing its real liability to just $120.

    But that's still too much of a spread, so Enron continues to hedge. Fortunately, the company has such a diversified trading floor that Enron mule-market experts can walk over to the traders in the warlord-militia derivatives department. Sure enough, at least four tribes near the Khyber Pass are increasingly concerned about profit margins. There simply aren't enough people to rob. Things have gotten so bad, in fact, that the warlords are hedging against the oncoming winter by taking futures positions in stolen chickens, stolen humanitarian aid trucks, and Western hostages.

    There's not a mule market yet, because the warlords have successfully converted many of the recalcitrant villagers into pack animals. But Enron knows how to MAKE markets. Quickly the numbers-crunchers go to work, and they soon determine that the average number of stolen mules per 100-man militia is 1.4 per year. That represents anywhere from $28 to $56 in lost mule-thievery income if the Khyber Pass is closed or inhospitable to traders from Pakistan. Amortizing that amount over 12 months, the warlords have an exposure of anywhere from $2.33 to $4.67 per month in lost pillage. Hence Enron announces the new Highway Robbery Derivative, in which each tribe is guaranteed the value of two stolen mules in each 12-month period in return for paying a premium of $4 per month.

    Enron's hedge is now complete, and it is a beautiful thing to behold. The chances of Ismail losing a mule to a raiding party are approximately one in 30, or 3.33 percent. Since he's paying $60 for his derivative contract, the expected loss of 3.33 percent of his herd would result in a payment of only $20 -- a more than comfortable spread. Meanwhile, if the mule is stolen by a warlord holding a Highway Robbery Derivative, then the payment to the other side would only be $28 against premiums of $48. If Ismail simply passes through the Khyber Pass without incident and sells all his mules at the standard price, Enron pockets $60 from Ismail and $48 each from four warlords, in addition to the previous profit of $31.70 from that heady Internet mule-futures trading day and the $20 in packaging commissions.

    If each warlord steals his standard 1.4 mules per year, then Enron still owes six-tenths of one mule to the warlord, or about $22.20 based on a $37 sale price. Total expected profit, based on 5.6 stolen mules, one of which is stolen from Ismail: $143.20. Total profit from all Ismail-related mule transactions: $194.90.

    See, it's simple when you know how it works. Ask Arthur Andersen.

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