chapter 18 managing financial risk with derivatives

Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.

Chapter 18Chapter 18Managing Financial Risk with Managing Financial Risk with DerivativesDerivatives

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Learning ObjectivesLearning Objectives

Understand the basic difference between hedging Understand the basic difference between hedging and speculating.and speculating.

Discern between hedging instruments including Discern between hedging instruments including futures, options, swaps, and products such as futures, options, swaps, and products such as interest rate ceiling, floor, and collars.interest rate ceiling, floor, and collars.

Develop appropriate interest rate hedging Develop appropriate interest rate hedging strategies.strategies.


Hedging vs. SpeculatingHedging vs. Speculating

A hedger has a cash position or an anticipated cash A hedger has a cash position or an anticipated cash position that he or she is trying to protect from position that he or she is trying to protect from adverse interest rate movementsadverse interest rate movements

A speculator has no operating cash flow position to A speculator has no operating cash flow position to protect and is trying to profit solely from interest protect and is trying to profit solely from interest rate movementsrate movements


Some Important TermsSome Important Terms

HedgerHedger SpeculatorSpeculator Perfect vs imperfect hedgePerfect vs imperfect hedge Pure vs anticipatory hedgePure vs anticipatory hedge Partial and cross hedgePartial and cross hedge Long (buy) and short (sell) hedgeLong (buy) and short (sell) hedge Mark to marketMark to market


HedgerHedger

An entity who uses the futures market to offset the price risksAn entity who uses the futures market to offset the price risks

associated with his basic business activities. By assuming a associated with his basic business activities. By assuming a

position in the futures market that is equal and opposite to hisposition in the futures market that is equal and opposite to his

position in the cash market, the hedger established a situationposition in the cash market, the hedger established a situation

where losses in the cash market are offset by gains in the where losses in the cash market are offset by gains in the

futures market and vice versa.futures market and vice versa.


SpeculatorSpeculator

An entity who takes a position in the futures market that is notAn entity who takes a position in the futures market that is not

offset by an opposite position in a basic line of business.offset by an opposite position in a basic line of business.


Perfect vs Imperfect HedgePerfect vs Imperfect Hedge

A A perfect hedge perfect hedge is one where the individual is able to eliminateis one where the individual is able to eliminate

all risk of price fluctuations.all risk of price fluctuations.


Pure vs Anticipatory HedgePure vs Anticipatory Hedge

A A pure hedge pure hedge is one where the individual assumes a position in is one where the individual assumes a position in

the futures market equal and opposite to the current positionthe futures market equal and opposite to the current position

in the cash market (such as hedging a riding the yield curve in the cash market (such as hedging a riding the yield curve

position).position).

An An anticipatory hedge anticipatory hedge is taking a position that is a temporaryis taking a position that is a temporary

substitute for an anticipated position in the cash market.substitute for an anticipated position in the cash market.


Partial and Cross HedgePartial and Cross Hedge

A A partial hedge partial hedge is where the person takes a position in theis where the person takes a position in the

futures market that is smaller than the cash position.futures market that is smaller than the cash position.

A A cross hedge cross hedge is where the manager uses a different hedgingis where the manager uses a different hedging

instrument (futures instrument) than the hedged cash instrument (futures instrument) than the hedged cash

instrument.instrument.


Long (buy) and Short (sell) HedgeLong (buy) and Short (sell) Hedge

A A long hedge long hedge is where the firm BUYS a futures contract.is where the firm BUYS a futures contract.

A A short hedge short hedge is where the firm SELLS a futures contract.is where the firm SELLS a futures contract.

A long hedge is appropriate when the firm will buy an asset inA long hedge is appropriate when the firm will buy an asset in

the future or sell a liability prior to maturity.the future or sell a liability prior to maturity.

A short hedge is appropriate when the firm issues a liabilityA short hedge is appropriate when the firm issues a liability

in the future or sells a current cash position in the future.in the future or sells a current cash position in the future.


Mark to MarketMark to Market

Everyday the gain or loss on a futures position causes yourEveryday the gain or loss on a futures position causes your

margin account to be adjusted, gains or credited to yourmargin account to be adjusted, gains or credited to your

account and losses or debited.account and losses or debited.


Hedging With Financial FuturesHedging With Financial Futures

IntroductionIntroduction Buy vs. sell hedgeBuy vs. sell hedge Choosing the instrumentChoosing the instrument Choosing the expiration dateChoosing the expiration date Choosing the number of contractsChoosing the number of contracts Performance evaluationPerformance evaluation


IntroductionIntroduction

A standardized contract that carries with it a A standardized contract that carries with it a performance obligation at expirationperformance obligation at expiration

Margin is generally required and is marked-to-Margin is generally required and is marked-to-market dailymarket daily

WSJ QuotesWSJ QuotesEurodollar (CME) - $1 mil.; pts of 100%Eurodollar (CME) - $1 mil.; pts of 100% Open Open

Open High Low Settle Chg Yield Chg Interest Open High Low Settle Chg Yield Chg InterestMar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463 Mar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463


Buy vs. Sell HedgeBuy vs. Sell Hedge

Type of hedge should depend on the nature of the Type of hedge should depend on the nature of the cash flow position being hedged, not on the cash flow position being hedged, not on the anticipated direction of interest rates.anticipated direction of interest rates.

Buy Hedge: A future investment or retiring a Buy Hedge: A future investment or retiring a liability prior to maturityliability prior to maturity

Sell Hedge: Issue a liability in the future or sell an Sell Hedge: Issue a liability in the future or sell an investment prior to its maturityinvestment prior to its maturity


Choosing the InstrumentChoosing the Instrument

Choice of instrument should be consistent with the Choice of instrument should be consistent with the nature of the cash flow being hedged.nature of the cash flow being hedged.

The interest rates should be highly correlated.The interest rates should be highly correlated.


Choosing the Expiration DateChoosing the Expiration Date

Choose the contract expiration month that occurs Choose the contract expiration month that occurs nearest to, but after, the date of the cash market nearest to, but after, the date of the cash market transaction to be hedged.transaction to be hedged.


Choosing the Number of ContractsChoosing the Number of Contracts

Size of cash market instrument Maturity of cash market instrumentSize of cash market instrument Maturity of cash market instrumentN = ----------------------------------------- x -----------------------------------------------N = ----------------------------------------- x ----------------------------------------------- Futures contract denomination Maturity of futures contract instr. Futures contract denomination Maturity of futures contract instr.


Performance Evaluation - Interest Performance Evaluation - Interest Rate Futures HedgeRate Futures Hedge

Change in the value of the cash positionChange in the value of the cash positionFace value cash x (SRFace value cash x (SR00 - SR - SR11) x (Mat) x (Matcc/360)/360)

Change in the value of the futures positionChange in the value of the futures positionFace value futures x (FRFace value futures x (FR00 - FR - FR11) x Mat) x Matff/360)/360)

Commission costCommission costNumber of contracts x Commission rateNumber of contracts x Commission rate

Opportunity cost of the marginOpportunity cost of the marginNumber of contracts x MRG x (D x k/360)Number of contracts x MRG x (D x k/360)


Performance Evaluation -Currency Performance Evaluation -Currency Futures HedgeFutures Hedge

Change in the value of the spot market positionChange in the value of the spot market positionFace value cash x (CXFace value cash x (CX00 - CX - CX11) = Gain (loss) spot) = Gain (loss) spot

Change in the value of the futures positionChange in the value of the futures positionFace value futures x (FXFace value futures x (FX00 - FX - FX11) = Gain (loss) futures) = Gain (loss) futures

Commission costCommission cost# contracts x Commission rate = Commission cost# contracts x Commission rate = Commission cost

Opportunity cost of the marginOpportunity cost of the margin# contracts x MRG x D x (k/360) = Margin cost# contracts x MRG x D x (k/360) = Margin cost


Why Hedges Are Not PerfectWhy Hedges Are Not Perfect

Futures contracts in general have only four Futures contracts in general have only four expiration dates per year. (Note T-bills: Mar, expiration dates per year. (Note T-bills: Mar, June, Sept, and Dec.June, Sept, and Dec.

Correlation coefficient of spot rates and futures Correlation coefficient of spot rates and futures rates is less than 1.0rates is less than 1.0


Hedging With OptionsHedging With Options

IntroductionIntroduction Type of hedge: write or purchase, call or putType of hedge: write or purchase, call or put Number of contractsNumber of contracts Performance evaluationPerformance evaluation



A A call option call option contract gives the buyer the “right” to contract gives the buyer the “right” to purchase the underlying asset at a specific price, purchase the underlying asset at a specific price, the striking price, over a specific span of time. The the striking price, over a specific span of time. The buyer pays a premium for this right.buyer pays a premium for this right.

A A put option put option allows the owner to sell the underlying allows the owner to sell the underlying asset at a specific price over a specific span of time. asset at a specific price over a specific span of time. The buyer pays a premium for this right. The buyer pays a premium for this right.

The options are on futures contracts for interest The options are on futures contracts for interest rate instrumentsrate instruments


Type of Hedge: Write or Purchase, Type of Hedge: Write or Purchase, Call or PutCall or Put

Purchase a call futures option to hedge a future Purchase a call futures option to hedge a future investment of cash or retire a liability before investment of cash or retire a liability before maturity.maturity.

Purchase a put futures option to hedge the future Purchase a put futures option to hedge the future issue of liabilities or the future liquidation of issue of liabilities or the future liquidation of financial assets.financial assets.


Number of ContractsNumber of Contracts

The number of options needed to purchase is based The number of options needed to purchase is based directly on the number of futures contracts needed. directly on the number of futures contracts needed. Refer to equation 18-1. Refer to equation 18-1.


Hedging With SwapsHedging With Swaps

IntroductionIntroduction Interest rate swapsInterest rate swaps

– Liability swapLiability swap

– Asset swapAsset swap

Foreign currency swapForeign currency swap



An interest rate swap occurs when two parties agree toAn interest rate swap occurs when two parties agree toexchange cash flow streams for a specified period of exchange cash flow streams for a specified period of time. Swaps are different from options and futures intime. Swaps are different from options and futures inthat they are not generally standardized and their that they are not generally standardized and their maturities are usually for longer time periods thanmaturities are usually for longer time periods thanmaturities of options and futures. maturities of options and futures.


Introduction, continuedIntroduction, continued

Interest rate swaps were created to take advantage of arbitrageInterest rate swaps were created to take advantage of arbitrageopportunities in the various fixed- and floating-rate capital opportunities in the various fixed- and floating-rate capital markets. Arbitrage opportunities exist because some marketsmarkets. Arbitrage opportunities exist because some marketsreact to change more rapidly than others, because creditreact to change more rapidly than others, because creditperceptions differ from market to market, and becauseperceptions differ from market to market, and becausereceptivity to specific debt structures differs from market toreceptivity to specific debt structures differs from market tomarket. If, for instance, a corporation wants term floating-ratemarket. If, for instance, a corporation wants term floating-ratefunds but finds that the market for its fixed-rate debt is com-funds but finds that the market for its fixed-rate debt is com-paratively cheaper than that for its floating-rate debt, then itparatively cheaper than that for its floating-rate debt, then itcan issue a fixed-rate bond and swap it into floating, for an can issue a fixed-rate bond and swap it into floating, for an all-in cost lower than that for a floating-rate bond or loan.all-in cost lower than that for a floating-rate bond or loan.source: The Government Securities Pink Booksource: The Government Securities Pink Book


Other DetailsOther Details

Notional AmountNotional Amount: the base on which all interest : the base on which all interest payments are computed. This amount generally payments are computed. This amount generally exceeds $25 million.exceeds $25 million.

RisksRisks: if the counterparty defaults: if the counterparty defaults Direct SwapDirect Swap: an agreement between two parties : an agreement between two parties

without the involvement of a financial without the involvement of a financial intermediaryintermediary

Indirect SwapIndirect Swap: the agreement is executed through : the agreement is executed through an intermediary which may assume some of the an intermediary which may assume some of the credit risk.credit risk.


Interest Rate Swap Diagram (Fixed-Interest Rate Swap Diagram (Fixed-for-Floating Liability Swap)for-Floating Liability Swap)

Counterparty ACounterparty A

Counterparty BCounterparty B

Counterparty ACounterparty A

Counterparty BCounterparty B

Borrows floating rateBorrows floating ratedebt but desires debt but desires $ $ $ $ $ $$ $ $ $ $ $fixed rate debtfixed rate debt

Pays off floating ratePays off floating ratedebt principal at debt principal at maturitymaturity

Borrows fixed rate Borrows fixed rate debt but desires debt but desires floating rate debtfloating rate debt

Pays off fixed ratePays off fixed ratedebt principal atdebt principal atmaturitymaturity

$ $ $ $ $ $$ $ $ $ $ $$ $ $ $ $ $$ $ $ $ $ $

Floating Rate Interest PaymentsFloating Rate Interest Payments

Fixed Rate Interest PaymentsFixed Rate Interest Payments$ $ $ $ $ $$ $ $ $ $ $

A A pays out fixed rate pays out fixed rateto to BB

BB pays out pays out floating rate to floating rate to AA

. . . . . . .

. . . . . . .


Liability SwapLiability Swap

k k swapswap = fr + so - si + fee = fr + so - si + fee

fr = financing ratefr = financing rateso = swap outflowso = swap outflowsi = swap inflowsi = swap inflowfee = intermediary feefee = intermediary fee

If If frfr is fixed rate then is fixed rate then soso is floating and is floating and sisi is fixed is fixedIf If frfr is floating then is floating then soso is fixed and is fixed and sisi is floating is floating


Asset SwapAsset Swap

kk swap swap = ir - so + si - fee = ir - so + si - fee

ir = investment returnir = investment returnso = swap outflowso = swap outflowsi = swap inflowsi = swap inflowfee = intermediary feefee = intermediary fee

If If irir is floating rate then is floating rate then soso is floating and is floating and sisi is fixed is fixedIf If irir is fixed rate then is fixed rate then soso is fixed and is fixed and sisi is floating is floating


A Currency Swap DiagramA Currency Swap Diagram

U. K. CompanyU. K. Company

U. S. CompanyU. S. Company

U. K. CompanyU. K. Company

U. S. CompanyU. S. Company

Borrows poundsBorrows poundssterling but swapssterling but swapsfor dollarsfor dollars

Re-exchanges $ forRe-exchanges $ forpounds sterling and pounds sterling and pays off debtpays off debt

Borrows dollars Borrows dollars and swaps for and swaps for pounds sterlingpounds sterling

Re-exchange £ forRe-exchange £ fordollars and pays offdollars and pays offdebtdebt

$ $ $ $ $ $$ $ $ $ $ $£ £ £ £ £ ££ £ £ £ £ £

Dollar Interest PaymentsDollar Interest Payments

Pound Sterling Interest PaymentsPound Sterling Interest Payments

. . . . . . .

. . . . . . .

$$

££ $$

££


Other Hedging InstrumentsOther Hedging Instruments

Interest rate capsInterest rate caps– Purchaser pays a premium and receives cash payments from the cap Purchaser pays a premium and receives cash payments from the cap

seller when the reference rate exceeds strike rate.seller when the reference rate exceeds strike rate.

– Cap payment = (ref - strk) x NP x LCap payment = (ref - strk) x NP x L

Interest rate floorsInterest rate floors– Purchaser pays a premium for the rate floor contract, receives cash Purchaser pays a premium for the rate floor contract, receives cash

payment when reference rate falls below strike rate.payment when reference rate falls below strike rate.

– Floor payment = (strk - ref) x NP x LFloor payment = (strk - ref) x NP x L

Interest rate collarsInterest rate collars– Purchase a rate cap and sell or issue a rate floor. Pay a premium for Purchase a rate cap and sell or issue a rate floor. Pay a premium for

the cap and receive a premium for the floor.the cap and receive a premium for the floor. [Floor payment - Cap payment] [Floor payment - Cap payment]

– Effective rate = REF + -----------------------------------------Effective rate = REF + ----------------------------------------- NP NP


SummarySummary

The chapter began by discussing the difference The chapter began by discussing the difference between hedging and speculating.between hedging and speculating.

The characteristics of different types of derivative The characteristics of different types of derivative instruments were presented.instruments were presented.

Hedging strategies for each instrument were Hedging strategies for each instrument were developed.developed.

Each section concluded with a section on how to Each section concluded with a section on how to evaluate the performance of the hedge.evaluate the performance of the hedge.

chapter 18 managing financial risk with derivatives

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