Derivatives

Fundamentals of risk management

Part 1. Fundamentals of Risk Management and Trading Tools for Auto Residual Value Risk

Futures Contracts and their Role

A futures contract is a standardized agreement that provides for a seller to deliver, and for a buyer to take delivery, of a specified quantity and quality of an identified commodity, at a fixed time in the future, at a price agreed to when the contract is first entered into.

Futures contracts are structured in two predominant ways: 1) physical settled and 2) cash settled. As the name indicates, physically settled contracts require physical delivery of the specified commodity (e.g. buyer takes delivery of bushels of corn from a warehouse), while cash settled contracts require the cash difference between traded price and final settlement price being paid out to buyer.

Exponential Markets Used Vehicle Derivatives are designed as cash settled instruments based on the Exponential AUTO index as the underlying. This means that the cash settlement for futures and options contracts is based on the relevant contract traded price and the final settlement price, which in turn is based on the Auto index price at contract expiration.

Key features of futures contracts, including EM Auto derivatives, are that:

• They are highly standardized with a fixed quantity, quality and time period
• They can only be traded on regulated exchanges
• They are mostly traded on an electronic trading system, with anonymous counterparties
• Are completely fungible, meaning each existing contract to buy can be readily offset by entering an identical contract to sell
• Up to expiry of the contract the buyer’s and seller’s counterparty is the clearing house through which the futures contracts are matched
• Subsequent to futures contract expiration the clearing house matches those buyers and sellers still holding open interest in contracts so that the commodity can be delivered or cash settled
• The clearing house oversees the delivery process in order to ensure compliance by both parties

Large, active futures markets now play a critical role in the management and financing of industry and commerce in such diverse sectors as:

• Banking (through use of future contracts based on interest rates and exchange rates)
• Oil and gas (through the use of futures contracts based on crude oil and refined products)
• Agriculture and Metals (through the use of futures contracts based on grain and industrial and precious metals)

Similar to the above large markets, the automotive sector is ripe for commoditization. There is over $500B in unhedged exposure to used vehicle price fluctuations in U.S. automotive finance portfolios.

The Role of Futures Markets

Futures markets have two central roles: risk transfer and price discovery.

Risk Transfer:

For market participants, the primary purpose of futures markets is to transfer the risk of adverse changes in commodity prices from those who wish to reduce risk to those willing to accept it. Commercial firms that produce or use the commodity shift part of the risk of price change to proprietary traders who willingly assume that risk for the opportunity to earn a profit on their venture capital.

The Exponential Used Vehicle Derivatives are cash settled futures and options contracts to manage vehicle residual value risk. To ensure an efficient risk transfer mechanism, this market has natural buyers and sellers on both sides of the trade.

The $500 billion total exposure mentioned earlier resides in a diverse set of market participants:

• Consumer Automotive Leasing (>$300B)
• Subprime Automotive Loans (>$100B)
• Daily Rental Fleets (>$50B)
• Other Commercial Fleets (>$50B)
• Auto Insurers (>$40B)

From a risk management perspective, consumer leasing portfolios, daily rental firms, and other commercial fleets all own a fleet of vehicles and therefore are directly exposed to used car price volatility. When the price of used cars decreases, these entities suffer a loss in their asset values and profitability. Similarly, lease portfolios, this exposure is primarily concentrated on the balance sheets of captive finance companies, banks, and credit unions that offer closed-end consumer leasing products. In contrast, the auto insurance sector requires protection against upward moves in vehicle price levels due replacement costs associated with policy coverage.

Price Discovery:

A critically important outcome of futures trading is the revelation of price information that reflects a multitude of market views, as expressed through the diverse traders involved in the markets. Because futures markets funnel large quantities of bids and offers that result in publicly disseminated transaction prices, future markets often become the primary source of price discovery for the related commodities.

Futures markets play an important economic and social role. By allowing market participants to reduce exposure to price, buyers and sellers can better plan their businesses. By revealing the market summary of the value of underlying products, futures markets inform those with a major stake in those commodities and financial instruments.

The availability of these markets has provided the means to allow greater risk to be absorbed, thus facilitating growth and efficiency in each of the associated industries. Market users have improved predictability of future business conditions, which allows for expansion of lending and commodity producers and facilitates borrowing for business growth. These results can lead to reductions in princes and interest rates paid by consumers.

The Exponential Auto Derivative contracts are an example of standardized terms of trade.

The standardized nature of futures markets makes them inexpensive and reliable to use. The standardization and efficiency benefits those with a commercial interest in the commodities that underlie a futures market. Because futures are readily accessible to both hedgers (who participate in order to reduce exposure to risk) and proprietary traders (who trade for the purpose of taking risk in the hope of making a profit), futures markets often become deep and liquid. Market depth and liquidity allows traders

Futures markets are derivative markets, which means they exist in relation to the cash market, which are the underlying primary markets in which the actual physical commodities are bought and sold. In the case of the used vehicle market, the underlying cash market is the used vehicle auctions conducted by various automotive auction houses across the country. Because futures contracts allow for the delivery of the underlying commodity upon expiration of the futures contract; there is a strong tendency for cash and futures prices to move in the same direction and react to the same economic factors.

Not every cash market has a futures market. Futures markets tend to develop in large, competitive cash markets that have volatile prices. In many basic commodities, price volatility is inherent and that volatility is a source of great financial risk for those who produce, market, process or finally consume these commodities and the products derived from them.

The used vehicle market has an active cash market in the form of used vehicle auctions that are conducted across the country.

As indicated below, the underlying cash market for used vehicles is volatile.