chapter 24 appendix 1 more on hedging with financial derivatives

Chapter 24Appendix 1

More on Hedging with Financial

Derivatives

Copyright ©2015 Pearson Education, Inc. All rights reserved. 24-2

Hedging withFinancial Futures

• Micro-hedge – hedge the interest-rate risk of a single asset.

• Macro-hedge – hedge the interest-rate risk of the overall portfolio, or firm.


Micro Hedge Example

• First National Bank holds $10 million in 10% T-bonds, maturing in 2025.

• Will use exchange-traded futures contract to hedge risk.

• Short position. But how many contracts? No perfect match in futures market.


Micro Hedge Example


Micro Hedge Example (a)


Micro Hedge Example (b)


Micro Hedge Example (c)


Micro Hedge Example (d)


Macro Hedge Example

• First National Bank holds $100 million in assets with a duration gap of 1.72 years.

• Will use exchange-traded futures contract to hedge risk.

• Short position. But how many contracts? No perfect match in futures market.


Macro Hedge Example


Macro Hedge Example (a)


Macro Hedge Example (b)


Futures Options Hedge Example

• First National Bank has a $2 million, 7%, four year loan commitment that expires in two months

• Will use exchange-traded futures options contract to hedge risk.

• Long put option on T-note futures. But how many contracts? Not a perfect match.


Futures Options Hedge Example (a)


Futures Options Hedge Example (b)


Futures Options Hedge Example (c)


Interest-Rate Swaps Hedge Example

• First National Bank holds $32 million and $49.5 million in rate-sensitive assets and liabilities, respectively.

• Use 10-year interest rate swap to hedge. ─ Receive 1% + 1-yr T-bill rate─ Pay fixed 7%

• What notional amount should be swapped?


Interest-RateSwaps Hedge Example


Interest-RateSwaps Hedge Example (a)


Macro Hedge Example (b)


Stock Index Futures

• Stock index futures can be used to hedge two situations:─ Reduce systematic risk─ Lock in stock prices


Stock Index FuturesReducing Systematic Risk

• Systematic risk – sensitivity of portfolio to changes in entire market

• Measured with beta (β)─ β = 0.5 means portfolio will increase 1% when

the market increases 2%.


Hedging with Stock Index Futures: Example

• Rock Solid stock portfolio of $100 million• β of portfolio is 1.0• Wants to reduce beta to zero using futures• Stock futures index contracts selling for

$1,000, contract size = $250,000


Hedging with Stock Index Futures: Example

• Must sell $100 million worth of futures, or $100 million / $250,000 = 400 contracts

• Market down 10%?─ Portfolio falls to $90 million─ Futures price falls $25,000 / contract, or a gain to

Rock Solid of $25,000 x 400 = $10 million


Hedging with Stock Index Futures


Hedging with Stock Index Futures: Example (a)


Hedging with Stock Index Futures: Example (b)


Stock Index FuturesLocking in Stock Prices

• Can lock-in prices of market level today.• Useful in situations where cash to buy a

position is on the way.


Stock Index FuturesLocking in Stock Prices: Example

• Today is January 1• Rock Solid expects to receive insurance

premiums of $20 million in March• March futures price is $1,000. Manger

forecasts price to rise 5% by March• Can lock-in price today!


Stock Index FuturesLocking in Stock Prices: Example

• Long position on 80 contracts─ 80 = $20 million / $250,000

• Market up 5%─Gain of $12,500 per contract, or $1 million!

chapter 24 appendix 1 more on hedging with financial derivatives

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