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Chapter Twenty Three

Chapter Twenty Three. HEDGING WITH FINANCIAL DERIVATIVES I: FORWARDS AND FUTURES. Interest-Rate Forward Markets. Long contract = buy securities at future date Locks in future interest rate Short contract = sell securities at future date

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Chapter Twenty Three

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  1. Chapter Twenty Three HEDGING WITH FINANCIAL DERIVATIVES I: FORWARDS AND FUTURES

  2. Interest-Rate Forward Markets • Long contract = buy securities at future date • Locks in future interest rate • Short contract = sell securities at future date • Locks in future price, so reduces price risk from change in interest rates • Pros • 1. Flexible • Cons • 1. Lack of liquidity: hard to find counter party • 2. Subject to default risk: Requires info to screen good from bad risk

  3. Financial Futures Markets • Traded on Exchanges: Global competition Regulated by CFTC • Financial Futures Contract • 1. Specifies delivery of type of security at future date • 2. Arbitrage  At expiration date, price of contract = price of the underlying asset delivered • 3. i, long contract has loss, short contract has profit • Differences in Futures from Forwards • 1. Futures more liquid: standardized, can be traded again, delivery of range of securities • 2. Delivery of range prevents corner • 3. Mark to market: avoids default risk • 4. Don't have to deliver: net long and short • Explains why futures so successful

  4. Widely Traded Financial Futures Contracts

  5. Hedging Interest-Rate Risk with Futures • Micro Hedge • Example: March 1997 hold $10 million 10s of 2010: How many March 1998 T-bond futures contracts need to sell to hedge over years • Hedge Ratio: $ amount futures per $ amount of hedged asset • HR = [ΔPa/ΔPf] x βaf • i 1%, ΔPa = 6.58%, ΔPf = 5.98%  • [ΔPa/ΔPf] = 6.58/5.98 = 1.10 • i 1% on futures, i 1% on hedged asset  βaf = 1.00 • HR =1.10 x 1.00 = 1.10 • # of contracts = HR x [PVa/PVf] • = 1.10 x $10 million/$100,000 • = 1.10 x 100 • = 110 contracts

  6. Macro Hedge • Example: DURgap = 1.72 years, Assets = $100m • Set Vf x DURf = - Va x DURgap • If DURf = 1.72 • Vf = -[Va x DURgap]/DURf • = -[$100m x 1.72]/1.72 = -$100m • = sell 1,000 contracts of $100,000 each • If DURf = 3.44 • Vf = -[$100m x 1.72]/3.44 = -$50m • = sell 500 contracts of $100,000 each • Problems with Hedges • 1. Basis Risk: i doesn't move perfectly together on hedged asset and futures • 2. Accounting Problems

  7. Hedging with Stock Index Futures • S&P Contract: cash delivery $500 x Index • Reducing Systematic Risk: Portfolio Insurance • # of contracts = beta x [Value of Portfolio/Value of Contract] • Example: $100m portfolio with beta = 1.0, S&P Index = 400 • # of contracts = 1.0 x [$100m/$200,000] • = 500 contracts • S&P  10%, $10m loss on portfolio • Futures: profit of $20,000 x 500 = $10m • Beta = 2.0 • # of contracts = 2.0 x [$100m/$200,000] • = 1,000 contracts

  8. Hedging with Stock Index Futures • S&P  10%, $20m loss on portfolio • Futures: profit of $20,000 x 1000 = $20m • Locking in Stock Prices • $20m to come in at future date, buy $20m of S&P futures • Hedging FX Risk • Example: Customer due 20 million DM in March, DM = $.50 in January • 1. Sell 20 million DM forward to deliver in March at $0.50 per DM • 2. Sell 20 million DM of March futures

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