Chapter 18 Managing Financial Risk with Derivatives

1. Chapter 18Managing Financial Risk with Derivatives • Order Order Sale Payment Sent Cash • Placed Received Received • Accounts Collection • < Inventory > < Receivable > < Float > • Time ==> • Accounts Disbursement • < Payable > < Float > • Invoice Received Payment Sent Cash Disbursed

2. Learning Objectives • Understand the basic difference between hedging and speculating. • Discern between hedging instruments including futures, options, swaps, and products such as interest rate ceiling, floor, and collars. • Develop appropriate interest rate hedging strategies.

3. Hedging vs. Speculating • A hedger has a cash position or an anticipated cash position that he or she is trying to protect from adverse interest rate movements • A speculator has no operating cash flow position to protect and is trying to profit solely from interest rate movements

4. Some Important Terms • Hedger • Speculator • Perfect vs imperfect hedge • Pure vs anticipatory hedge • Partial and cross hedge • Long (buy) and short (sell) hedge • Mark to market

5. Hedger An entity who uses the futures market to offset the price risks associated with his basic business activities. By assuming a position in the futures market that is equal and opposite to his position in the cash market, the hedger established a situation where losses in the cash market are offset by gains in the futures market and vice versa.

6. Speculator An entity who takes a position in the futures market that is not offset by an opposite position in a basic line of business.

7. Perfect vs Imperfect Hedge A perfect hedge is one where the individual is able to eliminate all risk of price fluctuations.

8. Pure vs Anticipatory Hedge A pure hedge is one where the individual assumes a position in the futures market equal and opposite to the current position in the cash market (such as hedging a riding the yield curve position). An anticipatory hedge is taking a position that is a temporary substitute for an anticipated position in the cash market.

9. Partial and Cross Hedge A partial hedge is where the person takes a position in the futures market that is smaller than the cash position. A cross hedge is where the manager uses a different hedging instrument (futures instrument) than the hedged cash instrument.

10. Long (buy) and Short (sell) Hedge A long hedge is where the firm BUYS a futures contract. A short hedge is where the firm SELLS a futures contract. A long hedge is appropriate when the firm will buy an asset in the future or sell a liability prior to maturity. A short hedge is appropriate when the firm issues a liability in the future or sells a current cash position in the future.

11. Mark to Market Everyday the gain or loss on a futures position causes your margin account to be adjusted, gains or credited to your account and losses or debited.

12. Hedging With Financial Futures • Introduction • Buy vs. sell hedge • Choosing the instrument • Choosing the expiration date • Choosing the number of contracts • Performance evaluation

13. Introduction • A standardized contract that carries with it a performance obligation at expiration • Margin is generally required and is marked-to-market daily • WSJ QuotesEurodollar (CME) - $1 mil.; pts of 100% Open Open High Low Settle Chg Yield Chg InterestMar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463

14. Buy vs. Sell Hedge • Type of hedge should depend on the nature of the cash flow position being hedged, not on the anticipated direction of interest rates. • Buy Hedge: A future investment or retiring a liability prior to maturity • Sell Hedge: Issue a liability in the future or sell an investment prior to its maturity

15. Choosing the Instrument • Choice of instrument should be consistent with the nature of the cash flow being hedged. • The interest rates should be highly correlated.

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

17. Choosing the Number of Contracts Size of cash market instrument Maturity of cash market instrumentN = ----------------------------------------- x ----------------------------------------------- Futures contract denomination Maturity of futures contract instr.

18. Performance Evaluation - Interest Rate Futures Hedge • Change in the value of the cash positionFace value cash x (SR0 - SR1) x (Matc/360) • Change in the value of the futures positionFace value futures x (FR0 - FR1) x Matf/360) • Commission costNumber of contracts x Commission rate • Opportunity cost of the marginNumber of contracts x MRG x (D x k/360)

19. Performance Evaluation -Currency Futures Hedge • Change in the value of the spot market positionFace value cash x (CX0 - CX1) = Gain (loss) spot • Change in the value of the futures positionFace value futures x (FX0 - FX1) = Gain (loss) futures • Commission cost# contracts x Commission rate = Commission cost • Opportunity cost of the margin# contracts x MRG x D x (k/360) = Margin cost

20. Why Hedges Are Not Perfect • Futures contracts in general have only four expiration dates per year. (Note T-bills: Mar, June, Sept, and Dec. • Correlation coefficient of spot rates and futures rates is less than 1.0

21. Hedging With Options • Introduction • Type of hedge: write or purchase, call or put • Number of contracts • Performance evaluation

22. Introduction • A call option contract gives the buyer the “right” to purchase the underlying asset at a specific price, the striking price, over a specific span of time. The buyer pays a premium for this right. • A put option allows the owner to sell the underlying asset at a specific price over a specific span of time. The buyer pays a premium for this right. • The options are on futures contracts for interest rate instruments

23. Type of Hedge: Write or Purchase, Call or Put • Purchase a call futures option to hedge a future investment of cash or retire a liability before maturity. • Purchase a put futures option to hedge the future issue of liabilities or the future liquidation of financial assets.

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

25. Hedging With Swaps • Introduction • Interest rate swaps • Liability swap • Asset swap • Foreign currency swap

26. Introduction An interest rate swap occurs when two parties agree to exchange cash flow streams for a specified period of time. Swaps are different from options and futures in that they are not generally standardized and their maturities are usually for longer time periods than maturities of options and futures.

27. Introduction, continued Interest rate swaps were created to take advantage of arbitrage opportunities in the various fixed- and floating-rate capital markets. Arbitrage opportunities exist because some markets react to change more rapidly than others, because credit perceptions differ from market to market, and because receptivity to specific debt structures differs from market to market. If, for instance, a corporation wants term floating-rate funds but finds that the market for its fixed-rate debt is com- paratively cheaper than that for its floating-rate debt, then it 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. source: The Government Securities Pink Book

28. Other Details • Notional Amount: the base on which all interest payments are computed. This amount generally exceeds $25 million. • Risks: if the counterparty defaults • Direct Swap: an agreement between two parties without the involvement of a financial intermediary • Indirect Swap: the agreement is executed through an intermediary which may assume some of the credit risk.

29. Interest Rate Swap Diagram (Fixed-for-Floating Liability Swap) Floating Rate Interest Payments Pays off floating rate debt principal at maturity Borrows floating rate debt but desires $ $ $ $ $ $ fixed rate debt . . . . . . . Counterparty A Counterparty A A pays out fixed rate to B $ $ $ $ $ $ $ $ $ $ $ $ B pays out floating rate to A . . . . . . . Counterparty B Counterparty B Borrows fixed rate debt but desires floating rate debt Pays off fixed rate debt principal at maturity $ $ $ $ $ $ Fixed Rate Interest Payments

30. Liability Swap • k swap = fr + so - si + feefr = financing rateso = swap outflowsi = swap inflowfee = intermediary fee • If fr is fixed rate then so is floating and si is fixedIf fr is floating then so is fixed and si is floating

31. Asset Swap • k swap = ir - so + si - feeir = investment returnso = swap outflowsi = swap inflowfee = intermediary fee • If ir is floating rate then so is floating and si is fixedIf ir is fixed rate then so is fixed and si is floating

32. A Currency Swap Diagram Dollar Interest Payments Re-exchanges $ for pounds sterling and pays off debt Borrows pounds sterling but swaps for dollars . . . . . . . U. K. Company U. K. Company $ £ $ $ $ $ $ $ £ £ £ £ £ £ £ $ . . . . . . . U. S. Company U. S. Company Borrows dollars and swaps for pounds sterling Re-exchange £ for dollars and pays off debt Pound Sterling Interest Payments

33. Other Hedging Instruments • Interest rate caps • Purchaser pays a premium and receives cash payments from the cap seller when the reference rate exceeds strike rate. • Cap payment = (ref - strk) x NP x L • Interest rate floors • Purchaser pays a premium for the rate floor contract, receives cash payment when reference rate falls below strike rate. • Floor payment = (strk - ref) x NP x L • Interest rate collars • Purchase a rate cap and sell or issue a rate floor. Pay a premium for the cap and receive a premium for the floor. [Floor payment - Cap payment] • Effective rate = REF + ----------------------------------------- NP

34. Summary • The chapter began by discussing the difference between hedging and speculating. • The characteristics of different types of derivative instruments were presented. • Hedging strategies for each instrument were developed. • Each section concluded with a section on how to evaluate the performance of the hedge.