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21

Hedging

Emery Finnerty Stowe

© Prentice Hall, 2004

Learning Objectives

Describe four basic types of derivative securities.

Use the Black–Scholes option pricing model (BS–

OPM) to value call and put options on common

stock, and also to value warrants.

Explain how a firm can force conversion of its

outstanding convertible securities.

Explain how a firm can use derivatives to hedge

specific risks.

Chapter Outline

20.1 Options

20.2 Warrants

20.3 Convertible Securities

20.4 Interest Rate Swaps

20.5 Forwards and Futures

20.6 Hedging

Derivatives, Hedging and the

Principles of Finance

Valuable Ideas

Options

Two-Sided Transactions

Risk-Return Trade-Off

Capital Market Efficiency

Comparative Advantage

Options

buy one share of the underlying stock at a

specified price within a stated time period.

A put option gives the holder the right to

sell one share of the underlying stock at a

specified price within a stated time period.

The fixed price is called the exercise or

strike price.

Some Properties of Options

value of call option increases.

value of put option decreases.

value of call option decreases.

value of put option increases.

value of call option increases.

value of put option increases.

Option Trading

Chicago Board of Options Exchange (CBOE)

NYSE

ASE

Pacific Stock Exchange

Philadelphia Stock Exchange

Over-the-counter options

Non-standardized contracts

Warrants

by the firm.

Entitles holder to buy a fixed number of shares

from the firm, at a stated price, within a stated

time period.

When a warrant is exercised, the number of

outstanding shares increases.

Convertible Debt

bond can be converted into a pre-specified number

of shares of the firm’s common stock.

Each bond can be converted into common stock at

a stated conversion price.

Conversion price exceeds issuer’s share price at the

time of issue by about 10% to 20%.

Conversion price is adjusted for stock splits, stock

dividends, rights offerings, and other distributions.

Convertible Debt

that can be purchased with one bond.

Bondholders who convert do not receive

accrued interest.

If bonds are called, conversion option

expires just before the redemption date.

Convertible Debt

always exceeds its conversion value (unless

the conversion option is about to expire).

The difference in the market value and the

bond’s conversion value is the time

premium of the conversion option.

Time premium is zero at option expiration.

Convertible Debt

any dividends, bondholders would never

convert voluntarily.

Sell the bond in the open market since the market

value exceeds the conversion value.

If the stock does pay dividends, bondholders

would not convert as long as the interest on the

bond exceeds the total dividends from the stock.

Forced Conversion

market value of the underlying stock,

bondholders will not voluntarily convert.

To force conversion, the firm should call

the bonds when the conversion value

reaches the effective call price.

The effective call price = optional

redemption premium plus accrued interest.

Convertible Preferred Stock

Convertible preferred stock can be exchanged

into shares of common stock, at the option of

the preferred stockholder.

Convertible exchangeable preferred stock

can be converted into convertible debt.

Black-Scholes Option Pricing

Model

Assumptions:

The option and the underlying asset trade in perfect markets.

The returns on the underlying assets are normally

distributed with a constant σ over the life of the option.

The riskless rate of interest is constant over the option’s life.

Option contracts are European (cannot be exercised prior to

maturity).

Underlying asset does not provide any cash flows over the

life of the option.

Black-Scholes Option Pricing

Model

S = Strike price of the call option.

P0 = current value of the underlying asset.

k = riskless APR with continuous compounding.

∆ t = time in years to option expiration.

σ = standard deviation of the (continuously

compounded) returns on the asset.

N(d) = Cumulative distribution function for a

standard normal random variable d.

Black-Scholes Option Pricing Model

ln( P0 / S ) + ∆tk σ ∆t

d1 = +

σ ∆t 2

d 2 = d1 − σ ∆t

Black-Scholes Option Pricing Model

Hightone Records. The current stock price is

$48, and the stock’s volatility is 30%. The

risk free rate is 5% per year. The call option

matures in 6 months and has a strike price of

$50.

Black-Scholes Option Pricing Model

ln( P0 / S ) + ∆tk σ ∆t

d1 = +

σ ∆t 2

ln(48 / 50) + .5 × .05 .30 .5

d1 = +

.30 .5 2

d1 = 0.03148

d 2 = d1 − σ ∆t = 0.03148 − .30 .5

d 2 = −0.18065

Black-Scholes Option Pricing

Model

N(d1) = 0.51256

N(d2) = 0.42832

= $3.7156

Put-Call Parity Relationship

Records. The put option also has a strike price

of $50 and expires 6 months from today.

We will use put-call parity:

PUT = $4.4811

Valuing Warrants

by the firm.

When a warrant is exercised, the number of

shares outstanding increases.

Let α be the proportionate increase in the

number of outstanding shares after all

warrants are exercised.

Valuing Warrants

is simple C/(1+α ) where C is the value of a

call option to buy one share.

After the warrant is issued, an efficient

market will reflect the dilution in the firm’s

stock price, and the warrant’s value is equal

to that of the call option.

Interest Rate Swaps

exchange specified cash flows at specified time

intervals.

The cash flows are determined by two different

interest rates.

The simplest interest rate swap involves swapping

fixed interest rates for floating interest rates, and

vice versa.

Only net cash flows are paid by one party to the

other.

Interest Rate Swaps

flows are based is called the notional

amount.

The notional amount is never exchanged.

Only the interest payments are.

Interest Rate Swaps

rate - floating rate swap with Megabass Corp.

The notional amount is $100 million.

Hightone agrees to pay 6-month LIBOR rate

and to receive a fixed 8% rate. The 6-month

LIBOR at the initiation of the swap is 6%.

The swap will last for 6 years.

Interest Rate Swaps

point of view is:

$100 million[ (8% - LIBOR)/2 ]

If the LIBOR rate is more than 8%,

Hightone pays cash to Megabass.

If the LIBOR rate is less than 8%, Hightone

receives cash from Megabass.

Interest Rate Swaps

7%.

Hightone will receive

$100M[(8%–7%)/2] = $500,000

from Megabass 6 months after the swap initiation date.

Suppose that six months after the swap is initiated,

the LIBOR rises to 9%.

Hightone will pay

$100M[(8% – 9%)/2] = $500,000

to Megabass six months later.

Why Use Interest Rate Swaps?

existing fixed rate loan into a floating rate loan

and vice versa.

Suppose 4 years ago, Hightone issued 10 year

$100 million face value bonds at an interest rate of

7.50%.

By entering into a 6-year swap with Megabass,

Hightone has converted its fixed rate loan into a

variable rate loan.

Why Use Interest Rate Swaps?

Hightone receives from Megabass 8.00%.

Hightone pays Megabass 6-month LIBOR.

Net Interest cost to Hightone is

LIBOR – 0.50%.

Thus, Hightone’s existing fixed rate loan

has been swapped into a floating rate loan

at a cost of (LIBOR – 0.50%).

Why Swaps Exist

Comparative advantage

Information asymmetries

Transaction costs

Forward Contracts

buy a specified amount of a particular asset

at a stated price on a particular date in the

future.

All terms of the contract are fixed at the time

the contract is entered into:

The amount of the asset.

The specified price (the exercise price).

Forward Contracts

contract is zero.

The buyer (or seller) will realize a profit only if the

actual market price of the asset is greater (less) than

the exercise price at time of delivery.

Forward contracts are a zero sum game.

The buyer’s profit (loss) equals the seller’s loss

(profit).

A forward contract has default risk.

Forward Contracts

the life of the contract.

Most forward contracts require physical

delivery, although some may be cash

settled.

In a cash settlement, the party incurring the loss

pays the amount of the loss to the counter-

party.

Forward Contracts

contract to purchase 50,000 bushels of corn from

Plain State Farms, at a forward price of $2.50 per

bushel. The delivery will take place in 90 days.

What will be Tasty Cereal’s profit in 90 days if the

market price of the corn is:

$2.25 per bushel.

$ 2.75 per bushel.

Forward Contracts

bushel, Tasty Cereal loses $12,500.

Loss = 50,000×($2.25 – $2.50) = ($12,500)

If the market price of corn is $2.75 per

bushel, Tasty Cereal gains $12,500.

Gain = 50,000×($2.75 – $2.50) = $12,500

Futures Contracts

contracts.

A long position in a futures contract obligates

you to take delivery of the underlying asset.

A short position in a futures contract

obligates you to make delivery of the

underlying asset.

The agreed-upon price at which the asset will

be traded in the future is called the futures

price.

Types of Futures Contracts

Corn, wheat, soybeans, canola

Livestock and meat

Cattle, hogs, pork bellies

Food and fiber

Cocoa, coffee, sugar, orange juice, cotton

Metals and petroleum

Copper, gold, silver, heating oil, crude oil

Types of Futures Contracts

Currency

Japanese yen, German mark, Mexican peso, Swiss

franc

Interest rates

Treasury bills, notes, and bonds, LIBOR, 30-day

federal funds

Stock indices

S&P 500, S&P midcap 400, NASDAQ 100, Nikkei,

FT-SE 100

Differences between Forward

and Futures Contracts

Forward contract profits (or losses) are recognized

only at maturity. Futures profits (or losses) are

recognized daily.

Marking to market

Futures contracts are traded on exchanges, while

forward contracts are traded over-the-counter.

Futures contract obligations can be offset by a

reversing trade on the exchange.

Differences between Forward

and Futures Contracts

Futures contracts have low default risk.

Futures contracts have greater liquidity.

A Treasury Bond Futures

Contract

Underlying asset is a $100,000 par value of a

hypothetical 20 year, 8% U.S. Treasury bond.

The contract (or futures) price is quoted with

respect to this bond.

The actual deliverable asset may be any one of

several eligible Treasury bonds.

Seller chooses the bond to be delivered.

Settlement is by physical delivery of the bond.

A Treasury Bond Futures

Contract

Suppose the futures price of the bond on

contract origination is 96.

The price in dollars is 96%($100,000) or

$96,000.

Assume that you go long in a 6-month

futures contract at this price.

A Treasury Bond Futures

Contract

One day after the contract is entered into,

interest rates fall.

Bond prices will rise.

Suppose the bond price is 96.50.

The long position makes a profit of $500:

$100,000 (96.50% – 96.0%) = $500.

The short position loses $500.

A Treasury Bond Futures

Contract

Two days after the contract is entered into, interest

rates rise.

Bond prices will fall.

Suppose the bond price is 95.50.

The long position loses $1,000:

$100,000×(95.50% – 96.50%) = $1,000.

The short position gains $1,000.

Cumulative loss for long position over two days is

$500 (= +$500 – $1,000)

Hedging

to changes in the price of a commodity, a foreign

exchange rate, or an interest rate.

Suppose interest rates increase:

Value of the firm falls.

Profits can be made on a short position in interest rate

futures.

A perfect hedge neutralizes the effect of changes

in interest rates.

Hedging

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Hedging

Options

Interest rate swaps

Futures contracts

Hedging with Options

The current share price is $50. You purchase

a put option on this stock, with an exercise

price of $50. The put costs $1.00, and expires

in 30 days.

What will be your net profit (loss) under

alternative stock prices 30 days later?

Hedging with Options

Price Stock Put Gain

$48 ($2) $2 $0 ($1)

$49 ($1) $1 $0 ($1)

$50 ($0) $0 $0 ($1)

$51 $1 $0 $1 $0

$52 $2 $0 $2 $1

$53 $3 $0 $3 $2

Protective Put (Synthetic Call)

$49

The solid green line is

the payoff of a

portfolio long in a

stock and a put.

ST

− $1

$50 profile as buying a

call option.

– $50

Hedging with Interest Rate

Swaps

A floating interest rate borrower can hedge

against adverse movements in interest rates

by entering into a swap to pay fixed and

receive floating.

Interest Rate Caps and Floors

specified interest rate rises above a

specified value.

It hedges against a rise in interest rates

An interest rate floor places a lower limit on

interest rates.

It hedges against a drop in interest rates.

Hedging with Forwards and

Futures

Suppose American Airlines is concerned

about possible future rise in fuel prices.

Hedge by buying oil futures.

Suppose the U.S. Export Company expects

to receive Japanese yen in the future, and is

concerned about the decline in the value of

the yen.

Hedge by selling yen futures (short position).

Hedging with Interest Rate

Futures

Interest rate futures can be used to hedge against

adverse movements in interest rates.

Your firm anticipates issuing bonds in the near

future.

You are concerned about rising interest rates.

Hedge by going short in Treasury bond futures.

Your firm anticipates a cash inflow in the near

future.

You are concerned about a drop in interest rates.

Hedge by going long in Treasury bond futures.

Hedge Ratio

to use in the hedge.

Hedge ratio =

Volatility of hedging instrument

Hedging with T-Bond Futures

million par value bonds in 30 days. Currently,

the interest rate on these bonds is 12%. The

current rate on 20-year, 8% Treasury bonds is

8%. Mason is concerned that interest rates

will rise during this time period. How can it

hedge this risk by selling Treasury bond

futures?

Hedging with T-Bond Futures

12%, it can issue 15-year bonds with a

coupon rate of 12% at their par value.

Since the current rate on 20-year, 8%

Treasury bonds is 8%, these bonds are also

selling at their par value.

What would be the value of these bonds if

interest rates rise by 1%?

Change in Value of Mason

Bonds

If the yield on Mason bonds rises by 1%, the value of 15-year, $100

par, 12% Mason bonds will be $93.4707.

$6.5293 = $100 – $93.4707

if yields rise by 1%.

Change in Value of T-Bonds

If the yield on Treasury bonds rises by 1%, the

value of 20-year, $100 par, 8% Treasury bonds

will be $ 90.7992.

$9.2008 = $100 – $ 90.7992

if yields rise by 1%.

The Hedge Ratio

0.70965.

Since each Treasury bond futures contract

involves $100,000 par value Treasury bonds,

Mason should sell 177 Treasury bond

contracts:

0.70965($25,000,000/$100,000) = 177

Value of Hedged Position

missed issuance opportunity cost to Mason

will be $1,632,325.

$25,000,000×(0.065293) = $1,632,325.

177($100,000)×(0.092008) = $1,628,542.

Net Effect of Hedge

interest rates would be $3,783.

$1,628,542 – $1,632,325 = $3,783.

This loss represents 0.23% of the missed

opportunity cost of $1,632,325.

The gain on futures equals 99.77% of the

missed opportunity cost.

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