Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Stock Price in Profit from Spending £50 to Buy 10


1 Year (£) Shares at £5 Each (£)
Profit from Spending £50 to Buy 100 Call-Options at 50 Pence Each (£)

3	–20	–50
4	–10	–50
5	0	–50
6	10	50
7	20	150
10	50	450
20	150	1450

As you can see, buying the options does particularly well if the stock price increases substantially. If the stock doubles to £10 you surely exercise the buy options to buy them for £5. You make £5 profit for every option that you own (£5 × 100 = £500), but don’t forget the £50 to purchase the options in the first place, leaving you with £450.

In contrast if you buy the shares, you make £5 profit per share, but because you only own 10 shares in total, you make £50. Notice, however, how the options perform terribly if the stock price fails to rise – you lose the whole stake. By owning the shares, your losses are more limited.

In general, although leverage increases the potential reward, it also increases the risk. Call-options are only considered a vanilla (simple) derivative. Derivative contracts can be as complex as you like, and many derivatives are substantially more complicated. Furthermore, financial

institutions take on leverage in many ways other than derivatives. We don’t go into them here, but the principle remains: leverage amplifies gains and losses. Leverage adds to the complexity and the interconnectedness of the financial system. It means losses (and gains) can be huge but also small changes in financial markets can have big effects on financial institutions.


Fearing contagion: When one gets sick, they all follow

Problems at one financial institution, which mean that it can’t meet its obligations to others, can lead to substantial losses and ultimately the failure of other financial businesses. Furthermore, these problems can be easily transmitted to the real economy (by which we mean things that you notice on a day-to-day basis about the economy, for example, increased unemployment or lower real wages).

This domino effect, in which the failure of one financial institution leads to failures at others and in businesses more generally, is known as a cascading failure. A nice name for a not so nice phenomenon.

Somewhat like hanging out with someone with the flu is likely to make you ill, having dealings with a financial institution with problems is likely to give you financial problems of your own. This financial contagion can happen in many ways, but we look at just one simply illustrative example.

Imagine that you own an airline – sure, jetting around the world for a while is fun, but at some point you have to sit down and make some important decisions. For example, you have to think carefully about fuel. Airlines purchase large amounts of fuel, so say that (at current prices) your airline spends £100 million a year on fuel.

Although fuel is a big chunk of your costs, you’re confident that it’s affordable. What worries you is that the price of fuel may rise in the future. In particular, you estimate that if the price of fuel rises by 20 per cent in the next year, you’ll make a loss and may have to exit the industry (no more free flights for you!). The question is: can you do anything today in order to protect yourself from the risk of fuel prices rising substantially in the future?

One thing you can do is approach a bank to see whether it would be willing to hedge (offset) your risk. How might this work? Well, wouldn’t it be great if the bank reimbursed you for the additional cost if fuel prices did increase? For example, if fuel prices increase by 30 per cent you’d have to spend an additional £30 million on fuel. This wouldn’t be a problem because the bank would pay you £30 million to offset the additional cost.


Here are the two (inevitable) catches:


If the price of fuel falls, you have to pay the bank any gains due to the price fall. For example, if fuel prices fall by 40 per cent – potentially saving you £40 million – you have to pay the bank £40 million. Thus the bank is offering you a service that looks a lot like insurance: whatever happens to the price of fuel, the effective amount that you pay for fuel remains unchanged.


The bank is unlikely to offer this insurance for free. It demands to be compensated for taking the risk off your hands. Say that the bank charges £5 million for this service, which you have to pay regardless of what happens to the oil price. If you enter into this agreement, you will (in theory) pay £105 million (£100 million + £5 million) regardless of what happens to the price of fuel. This ensures that you don’t go out of business if fuel prices skyrocket. This type of contract is called a swap (see Figure 14-2).


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Figure 14-2: Hedging.

So far everything looks hunky-dory: your airline is hedged (insured) against

changes in the price of fuel, and the bank is happy because it’s getting paid for its services.

But your bank is now holding quite a lot of risk – if the price of fuel rises a lot, it will have to make large payments to you. Can it do anything about this? Well, yes, with a little bit of financial magic, it can. You see, although airlines dislike high fuel prices, airline fuel producers like them. Say that FuelCorp produces airline fuel – what really worries it is that fuel prices will collapse and leave the firm bankrupt. Therefore it can enter into a similar contract to yours with some other bank, except that this time the bank makes payments to FuelCorp if fuel prices fall and FuelCorp makes payments to the bank if fuel prices rise. This hedges FuelCorp’s risk, because it’s now guaranteed a certain price for its fuel (see Figure 14-3).

© John Wiley & Sons


Figure 14-3: FuelCorp hedging.

Both your airline and FuelCorp are now protected from changes in the price of fuel. You’ve guaranteed the price that you pay for fuel, and FuelCorp has guaranteed the price it receives for fuel. But what about the banks? Well, your bank has taken on your risk – so it loses money if fuel prices rise and makes money if fuel prices fall. And FuelCorp’s bank has taken on its risk – so it loses money if fuel prices fall and makes money if they rise. Because your bank does well when FuelCorp’s bank does badly (and vice versa), they can hedge each other by entering into the following swap: if fuel prices rise, FuelCorp’s bank makes a payment to your bank, and if fuel prices fall, your bank makes a payment to FuelCorp’s bank.

Looking at Figure 14-4, you can see that not only are your airline and FuelCorp hedged, but the two banks aren’t holding any of the risks associated with changes in the price of fuel. The financial system appears to have done its job well: it has acted as an intermediary between your airline (which wanted to fix the price it paid for fuel) and FuelCorp (which wanted to fix the price it received for fuel). Economists get quite excited when markets work the way they’re supposed to by allowing parties to enter into contracts that make them all better off. But this isn’t the end of the story. Contagion hasn’t yet reared its ugly head.


© John Wiley & Sons


Figure 14-4: Taking away all the risk?


Economists say that the market risk has been eliminated due to these transactions, that is, the risks associated with the uncertain future price of fuel. But another risk applies here – called counterparty risk – that one of the institutions you’ve dealt with won’t honour its side of the bargain. Counterparty risk can be a huge problem and can lead to the wholesale unravelling of all these contracts.

Imagine that FuelCorp’s bank gets into some kind of trouble (possibly due to a bank run – see the earlier section ‘Experiencing bank runs: Why any bank can fail’), which means it can’t honour its liabilities. This situation is likely to cause substantial difficulties for anyone who does business with FuelCorp. Suppose that fuel prices rise substantially: ordinarily this would trigger a payment from FuelCorp’s bank to your bank. But FuelCorp’s bank is in trouble and can no longer make this payment. You’re also due a payment from your bank to compensate you for the higher fuel price. As you can see, the waters are getting murkier as the ‘virus’ threatens to spread.

Your payment should’ve been straightforward, with any money your bank owed to you being covered by the payment made to your bank from FuelCorp’s bank. Your bank still has to honour its obligation to you regardless of the failure of FuelCorp’s bank. However, your bank may have

been relying heavily on the offsetting payment, which will now no longer be paid. This has the potential to cause substantial difficulties for your bank. So much so, that it may be unable to make its payment to you, which in turn may cause your airline to fail.

The contagion we mention at the start of this section has finally reached you after different companies have sneezed on each other – and now your firm has caught a nasty cold.

The problem isn’t just the large amounts of complex transactions taking place between financial institutions – it’s the fact that these transactions are often opaque.