Finance II (431) Professor Ponticelli

Homework Assignment 8
Risk Management

1) Oil refiners purchase crude oil and refine it into products like gasoline, jet fuel and
petrochemicals. During the production process they hold crude oil in inventory. The value of their
inventories rises (falls) when crude oil prices rise (fall). As a result, refiners often use derivatives
contracts on crude oil to offset these effects. Assume the one year risk free rate is 1% and the
average excess return on the market portfolio is 7.6%.

A) You have been hired by a refiner to advise on its inventory hedging program. If the goal
is to offset the changes in inventory value caused by crude oil price changes, should the
refiner purchase or sell crude oil futures contracts?

B) The one year futures price of a barrel of crude oil is $59. Analysts anticipate that the price
of crude oil in one year will be either $80 or $40, with equal probability. Under the
assumption that these estimates accurately reflect the beliefs of market participants, solve
for the implied CAPM beta of an investment in crude oil.

C) Your client is most interested in offsetting a reduction in the value of its inventory. What
options transaction would you recommend to achieve this goal? (You do not need to
determine the appropriate exercise price.)

D) You agree with analysts’ forecasts for the expected price of oil in one year, but you
believe that the price will be either $90 or $30, with equal probability. Given this belief,
which hedging transaction would create more value for the refiner, the futures transaction
from part (a) or the options transaction from part (c)?

E) Required maintenance expenditures at refineries are highest during periods of strong

economic performance, when demand for crude oil is high. If your client’s primary
investments are maintenance expenditures, is hedging valuable?

2) Bay Star Electronics (BSE) is a U.S.-headquartered and NASDAQ-listed producer of electronic

goods. BSE has decided to borrow $10M to generate interest tax shields and thus raise the value
of the firm. The debt is issued at face value and has a maturity of one year. Because the firm is
currently all equity, treat the debt as having zero default risk. If Bay Star borrows in the U.S.
market, it will have to pay 4% interest. If the firm borrows in the Japanese market, it will have to
pay only 3%. Assume there are no regulatory or tax barriers to borrowing abroad.

A) BSE decides to borrow $10M in the Japanese market by issuing bonds. The exchange
rate is currently ¥100/$. What is the firm's obligation in ¥ next year?

B) Borrowing in the Japanese market, as opposed to the U.S. market, appears to be an

arbitrage opportunity -- 3 percent is smaller than 4 percent. Is it actually an arbitrage
opportunity? Think about how BSE views its liability

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 C) BSE can buy ¥ and sell dollars one year hence through a futures/forward contract. It can
lock in a price of ¥99/$ for a December 2010 delivery. Which is better from Bay Star’s
perspective -- borrowing in the U.S. or borrowing in Japan and entering into the forward
contract to buy ¥ next year?

D) BSE’s investment banker argues that, on average, the exchange rate in December 2010
will be 100¥/$, not 99¥/$. Indeed, historical data shows that the one year forward price
consistently underestimates the actual ¥/$ exchange rate (the spot price) one year hence.
Is it therefore true that BSE can increase the expected cash flow it pays to shareholders
by leaving its Yen obligations unhedged?

E) Assuming the futures contract is correctly priced, would Bay Star be paying a risk
premium, receiving a risk premium, or neither by purchasing Yen forward?

F) A large portion of Bay Star’s sales are high-end digital cameras, which are sold in Japan,
but manufactured by Bay Star in the U.S. Assuming that Bay Star wants to reduce the
volatility of its cash flows, should it purchase Yen forward to hedge its Yen debt
obligation?

3) Interest rate hedging at Procter & Gamble. On April 12, 1994, P&G announced it would take a
one-time charge of $157 million to close out two interest rate swaps it had purchased through
Bankers Trust. P&G claimed it did not fully understand the swaps into which it had entered.
“Derivatives like these are dangerous and we were badly burned,” said CEO Edwin Artzt. 1 Some
have argued that the swaps into which P&G entered were quite complicated and very difficult to
understand. “Nobody knows for sure how P&G lost $153 million.” 2 Since you are smarter, I
would like you to analyze P&G’s hedge, based on the attached article from the New York Times.

A) According to the New York Times, Procter & Gamble entered into a swap where they
agreed to pay a spread above the commercial paper rate. The spread was calculated as:

Spread = max[0 , 17.0415 * r 5 year treasury - P30 year treasury w/ coupon rate of 6.25% ] - 0.0075 (1)

The price of a 30 year treasury note can be written as a function of the rate on a 30 year
treasury bond. The following formula calculates the price per dollar of face value, which
is the price used in the spread formula above.

0.0625  
60 *1  
∑ 2 1 0.0625 * 1  1 + 1
P30 yr = + = 1- (2)
t 60  60  60
 r 30   r 30  r 30
  r 30   1 + r 30 
1 +  1 +  1 + 
t =1

 2   2    2    2 

The payments on P&G’s swap thus depend on the 5 and 30 year government bond rates.

1
Derivatives Strategy, April 25, 1994, page 1.
2
Ibid, page 3.

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 Construct a table which reports the spread as a function of the 5 and 30 year interest rates.

P&G Spread Thirty year rate

Five year rate 5% 6% 7% 8%

5%

6%

7%

8%

B) Although this derivative is more complicated than a simple bet on the direction of interest
rates, would you characterize this as a bet on rates rising or falling? How is this
derivative different from a direct fixed for floating rate swap? A fixed for floating swap
can also be used to bet on the direction of future interest rates.

C) What must P&G’s risk exposure to interest rates look like to justify this hedge?

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October 30, 1994
MARKET WATCH

By Floyd Norris

THE wonderful world of interest rate swaps has largely been hidden from public view. Now, as some of
the big losers in the game cry foul and sue, more of it is coming to light.

Last week, Procter & Gamble became the second Cincinnati company to sue Bankers Trust. Like
Gibson Greeting Cards a few weeks earlier, P.& G. sees itself as a swindled innocent that relied on the
advice of a slick New York hustler and lost millions.

Bankers Trust, in its response to the Gibson suit, paints a far different picture. It was no trusted
adviser, it says, just a trader. Gibson was a sophisticated company that made a bet on interest rates,
and Bankers Trust took the other side. Gibson lost. Too bad. Its response to P.& G. is likely to be
similar.

It is far too early to judge the merits of the claims, but several things are clear. Both Gibson and P.& G.
ended up taking amazing risks, with the potential of huge losses if interest rates rose. Gibson says it
took the riskiest of those chances only under duress, when losses were piling up from other bets whose
details it will not disclose. P.& G. says it relied on promises from Bankers Trust that it could get out
before the losses mounted.

Behind both cases is a trend that built up in the 1980's, of the corporate treasurer as a profit center,
able to use sophisticated techniques to get more money on idle cash while saving money on borrowing.
More and more they turned to banks for clever ideas and, if these cases are any example, accepted
risks that they did not understand.

In a simple interest rate swap, a company that is paying a fixed rate on a bond issue is relieved of the
duty to pay it, instead agreeing to pay a floating rate. That was what happened to both P.& G. and
Gibson, but in their cases they agreed to complicated formulas that meant the rates they paid could
soar to incredible heights. P.& G.'s formula was as follows: Six months after the deal was signed,
multiply the yield on 5-year Treasuries by 17.0415 and then subtract the price of the outstanding
30-year Treasury, which had a coupon of 6.25 percent. That figure, less 0.75 percentage points, was
the margin above commercial paper that would be paid, in most cases.

Under that formula, P.& G. stood to save a little if rates fell or rose just a bit, but to lose big if rates
jumped. Given what actually happened to rates, P.& G. could have been forced to pay more than 30
percent a year.

P.& G. says Bankers Trust promised it could get out well before that happened, under a complicated
option that Bankers Trust did not explain. P.& G. says it was told that changes in interest rates and the
volatility of rates would have little effect on the price of the option. If that was said, and believed, it is
breathtaking. Anyone who knew anything about option pricing would have laughed at such a claim.
(Bankers Trust says there was no option deal at all, just a promise to quote a price if P.& G. wanted out
early.) Eventually, P.& G. got out, but it will pay rates approaching 20 percent for four years unless the
court intervenes.

These suits make it clear that corporate treasurers who said they were hedging were really gambling on
declining interest rates. Perhaps they were misled by Bankers Trust, whose stock certainly has suffered
since the ruckus began. But it is hard to escape the conclusion that big companies like this should not
be playing games they don't understand.

Graphs showing yield on 5- and 30- year treasury bonds and change of Bankers Trust stocks and the
S.&P. money center bank index in 1994.

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