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Derivatives and Hedging Risk

Derivatives and Hedging Risk. Key Concepts and Skills. Understand the basics of forward and futures contracts Understand how derivatives can be used to hedge risks faced by the corporation. 25.1 Derivatives, Hedging, and Risk 25.2 Forward Contracts 25.3 Futures Contracts 25.4 Hedging

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Derivatives and Hedging Risk

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  1. Derivatives and Hedging Risk

  2. Key Concepts and Skills • Understand the basics of forward and futures contracts • Understand how derivatives can be used to hedge risks faced by the corporation

  3. 25.1 Derivatives, Hedging, and Risk 25.2 Forward Contracts 25.3 Futures Contracts 25.4 Hedging 25.5 Interest Rate Futures Contracts 25.6 Duration Hedging 25.7 Swap Contracts 25.8 Actual Use of Derivatives Chapter Outline

  4. 25.2 Forward Contracts • A forward contract specifies that a certain commodity will be exchanged at a specified time in the future at a price specified today. • Its not an option: both parties are expected to hold up their end of the deal. • If you have ever ordered a textbook that was not in stock, you have entered into a forward contract.

  5. 25.3 Futures Contracts • A futures contract is like a forward contract: • It specifies that a certain commodity will be exchanged at a specified time in the future at a price specified today. • A futures contract is different from a forward: • Futures are standardized contracts trading on organized exchanges with daily resettlement (“marking to market”) through a clearinghouse.

  6. Futures Contracts • Standardizing Features • Contract Size • Delivery Month • Daily resettlement • Minimizes the chance of default • Initial Margin • About 4% of contract value • Cash or T-bills held in a street name at your brokerage

  7. Currently $1 = ¥140. The 3-month forward price is $1=¥150. Daily Resettlement: An Example Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically, you think that the dollar will appreciate).

  8. $1 $3,333.33 = 0.04 × ¥12,500,000 × ¥150 Daily Resettlement: An Example • Currently $1 = ¥140, and it appears that the dollar is strengthening. • If you enter into a 3-month futures contract to sell ¥ at the rate of $1 = ¥150 you will profit if the yen depreciates. The contract size is ¥12,500,000 • Your initial margin is 4% of the contract value:

  9. $1 $1 $83,333.33 = ¥12,500,000 × $83,892.62 = ¥12,500,000 × ¥150 ¥149 Daily Resettlement: An Example If tomorrow the futures rate closes at $1 = ¥149, then your position’s value drops (¥ appreciated). Your original agreement was to sell ¥12,500,000 and receive $83,333.33: But, ¥12,500,000 is now worth $83,892.62: You have lost $559.29 overnight.

  10. $1 $3,355.70 = 0.04 × ¥12,500,000 × ¥149 Daily Resettlement: An Example • The $559.29 comes out of your $3,333.33 margin account, leaving $2,774.04. • This is short of the $3,355.70 required for a new position. Your broker will let you slide until you run through your maintenance margin. Then you must post additional funds, or your position will be closed out. This is usually done with a reversing trade.

  11. Selected Futures Contracts

  12. Futures Markets • The Chicago Mercantile Exchange (CME) is by far the largest. • Others include: • The Philadelphia Board of Trade (PBOT) • The MidAmerica Commodities Exchange • The Tokyo International Financial Futures Exchange • The London International Financial Futures Exchange

  13. Wall Street Journal Futures Price Quotes Highest price that day Highest and lowest prices over the lifetime of the contract. Opening price Closing price Daily Change Lowest price that day Expiry month Number of open contracts

  14. Basic Futures Relationships • Open Interest refers to the number of contracts outstanding for a particular delivery month. • Open interest is a good proxy for the demand for a contract. • Some refer to open interest as the depth of the market. The breadth of the market would be how many different contracts (expiry month) are outstanding.

  15. 25.4 Hedging • Two counterparties with offsetting risks can eliminate risk. • For example, if a wheat farmer and a flour mill enter into a forward contract, they can eliminate the risk each other faces regarding the future price of wheat. • Hedgers can also transfer price risk to speculators, who absorb price risk from hedgers. • Speculating: Long vs. Short

  16. Hedging and Speculating: Example You speculate that copper will go up in price, so you go long 10 copper contracts for delivery in 3 months. A contract is 25,000 pounds in cents per pound and is at $0.70 per pound, or $17,500 per contract. If futures prices rise by 5 cents, you will gain: Gain = 25,000 × .05 × 10 = $12,500 If prices decrease by 5 cents, your loss is: Loss = 25,000 ×(–.05) × 10 = –$12,500

  17. 50,000 bushels 10 contracts = 5,000 bushels per contract Hedging: How many contracts? You are a farmer, and you will harvest 50,000 bushels of corn in 3 months. You want to hedge against a price decrease. Corn is quoted in cents per bushel at 5,000 bushels per contract. It is currently at $2.30 cents for a contract 3 months out, and the spot price is $2.05. To hedge, you will sell 10 corn futures contracts: Now you can quit worrying about the price of corn and get back to worrying about the weather.

  18. 25.5 Interest Rate Futures Contracts • Pricing of Treasury Bonds • Pricing of Forward Contracts • Futures Contracts • Hedging in Interest Rate Futures

  19. … 0 1 2 3 2T Pricing of Treasury Bonds Consider a Treasury bond that pays a semiannual coupon of $C for the next T years: • The yield to maturity is R Value of the T-bond under a flat term structure = PV of face value + PV of coupon payments

  20. … 0 1 2 3 2T Pricing of Treasury Bonds If the term structure of interest rates is not flat, then we need to discount the payments at different rates depending upon maturity. = PV of face value + PV of coupon payments

  21. … 0 NN+1 N+2 N+3 N+2T Pricing of Forward Contracts An N-period forward contract on that T-Bond: Can be valued as the present value of the forward price.

  22. 1,000 × .06 30 = 2 Pricing of Forward Contracts: Example Find the value of a 5-year forward contract on a 20-year T-bond. The coupon rate is 6 percent per annum, and payments are made semiannually on a par value of $1,000. N 40 = 20 × 2 The Yield to Maturity is 5 percent. First, set your calculator to 2 payments per year. Then enter what you know and solve for the value of a 20-year Treasury bond at the maturity of the forward contract. I/Y 5 –1,125.51 PV PV PMT FV 1,000

  23. Pricing of Forward Contracts: Example First, set your calculator to 1 payment per year. Then, use the cash flow menu: 5 CF0 0 I 881.86 CF1 0 NPV F1 5 –1,125.51 CF2 F2 1

  24. Pricing of Futures Contracts • The pricing equation given above will be a good approximation. • The only real difference is the daily resettlement.

  25. Hedging in Interest Rate Futures • A mortgage lender who has agreed to loan money in the future at prices set today can hedge by selling those mortgages forward. • It may be difficult to find a counterparty in the forward who wants the precise mix of risk, maturity, and size. • It is likely to be easier and cheaper to use interest rate futures contracts.

  26. 25.6 Duration Hedging • As an alternative to hedging with futures or forwards, one can hedge by matching the interest rate risk of assets with the interest rate risk of liabilities. • Duration is the key to measuring interest rate risk.

  27. Duration Hedging • Duration measures the combined effect of maturity, coupon rate, and YTM on a bond’s price sensitivity to interest rates. • Measure of the bond’s effective maturity • Measure of the average life of the security • Weighted average maturity of the bond’s cash flows

  28. Duration Formula

  29. Calculating Duration: Example Calculate the duration of a three-year bond that pays a semiannual coupon of $40 and has a $1,000 par value when the YTM is 8%.

  30. Duration is expressed in units of time, usually years. Calculating Duration: Example

  31. Duration Properties: • Longer maturity, longer duration • Duration increases at a decreasing rate • Higher coupon, shorter duration • Higher yield, shorter duration • Zero coupon bond: duration = maturity

  32. 25.7 Swaps Contracts • In a swap, two counterparties consent to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. • There are two types of interest rate swaps: • Single currency interest rate swap • “Plain vanilla” fixed-for-floating swaps are often just called interest rate swaps. • Cross-Currency interest rate swap • This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

  33. The Swap Bank • A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. • The swap bank can serve as either a broker or a dealer. • As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. • As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

  34. An Example of an Interest Rate Swap • Consider this example of a “plain vanilla” interest rate swap. • Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans. • Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent. • It would make more sense to for the bank to issue floating-rate notes at LIBOR to finance floating-rate Eurodollar loans.

  35. An Example of an Interest Rate Swap • Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life. • Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent. • Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + ½ percent. • Firm B would prefer to borrow at a fixed rate.

  36. An Example of an Interest Rate Swap The borrowing opportunities of the two firms are:

  37. 10 3/8% LIBOR – 1/8% An Example of an Interest Rate Swap The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10 million for 5 years, and we will pay you 10 3/8% on $10 million for 5 years Swap Bank Bank A

  38. 10 3/8% LIBOR – 1/8% 10% An Example of an Interest Rate Swap ½% of $10,000,000 = $50,000. That’s quite a cost savings per year for 5 years. Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR – 1/8) = LIBOR – ½ %, which is ½ % better than they can borrow floating without a swap. Swap Bank Bank A

  39. 10 ½% LIBOR – ¼% An Example of an Interest Rate Swap The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years, and we will pay you LIBOR – ¼ % per year on $10 million for 5 years. Swap Bank Company B

  40. 10 ½% LIBOR – ¼% An Example of an Interest Rate Swap Here’s what’s in it for B: ½ % of $10,000,000 = $50,000 that’s quite a cost savings per year for 5 years. Swap Bank They can borrow externally at LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating. Company B LIBOR + ½%

  41. 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% An Example of an Interest Rate Swap The swap bank makes money too. ¼% of $10 million = $25,000 per year for 5 years. Swap Bank Bank A Company B LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 10 ½ - 10 3/8 = 1/8 ¼

  42. 10 3/8% 10 ½% LIBOR – 1/8% LIBOR – ¼% An Example of an Interest Rate Swap The swap bank makes ¼% Swap Bank Bank A Company B A saves ½% B saves ½%

  43. An Example of a Currency Swap • Suppose a U.S. MNC wants to finance a £10,000,000 expansion of a British plant. • They could borrow dollars in the U.S. where they are well known and exchange dollars for pounds. • This will give them exchange rate risk: financing a sterling project with dollars. • They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.

  44. An Example of a Currency Swap • If they can find a British MNC with a mirror-image financing need they may both benefit from a swap. • If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000.

  45. An Example of a Currency Swap Consider two firms A and B: firm A is a U.S.–based multinational and firm B is a U.K.–based multinational. Both firms wish to finance a project in each other’s country of the same size. Their borrowing opportunities are given in the table below.

  46. $8% $9.4% £11% £12% $8% £12% An Example of a Currency Swap Swap Bank Firm A Firm B

  47. $8% £11% £12% An Example of a Currency Swap A’s net position is to borrow at £11% Swap Bank $9.4% Firm A Firm B $8% £12% A saves £.6%

  48. $8% £11% £12% An Example of a Currency Swap B’s net position is to borrow at $9.4% Swap Bank $9.4% Firm A Firm B $8% £12% B saves $.6%

  49. $8% £11% £12% An Example of a Currency Swap The swap bank makes money too: 1.4% of $16 million financed with 1% of £10 million per year for 5 years. Swap Bank $9.4% Firm A Firm B $8% At S0($/£) = $1.60/£, that is a gain of $64,000 per year for 5 years. £12% The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).

  50. Variations of Basic Swaps • Currency Swaps • fixed for fixed • fixed for floating • floating for floating • amortizing • Interest Rate Swaps • zero-for floating • floating for floating • Exotics • For a swap to be possible, two humans must like the idea. Beyond that, creativity is the only limit.

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