Corporate Finance 11th Edition Ross Solutions Manual

Corporate Finance 11th Edition Ross Solutions
Manual
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ual/
Corporate Finance 11th Edition Ross Solutions Manual
Chapter 25 - Derivatives and Hedging Risk
CHAPTER 25
DERIVATIVES AND HEDGING RISK
25-1
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25.1 Key Concepts and Skills

25.2 Chapter Outline
25.3 Forward Contracts
25.4 Futures Contracts
25.6 Daily Resettlement: An Example
25.10 Selected Futures Contracts
25.11 Futures Markets
25.12 Wall Street Journal Futures Price Quotes
25.13 Basic Futures Relationships
25.14 Hedging
25.15 Hedging and Speculating: Example
25.16 Hedging: How many contracts?
25.17 Interest Rate Futures Contracts
25.18 Pricing of Treasury Bonds
25.19 Pricing of Treasury Bonds
25.20 Pricing of Forward Contracts
25.21 Pricing of Forward Contracts: Example
25.22 Pricing of Forward Contracts: Example
25.23 Pricing of Futures Contracts
25.24 Hedging in Interest Rate Futures
25.25 Duration Hedging
25.27 Duration Formula
25.28 Calculating Duration: Example
25.29 Calculating Duration: Example
25.30 Duration
25.31 Swaps Contracts
25.32 The Swap Bank
25.33 An Example of an Interest Rate Swap
SLIDES
25-2

25.42 An Example of a Currency Swap
25.49 Credit Default Swaps
25.50 Variations of Basic Swaps
25.51 Risks of Interest Rate and Currency Swaps
25.52 Risks of Interest Rate and Currency Swaps
25.53 Pricing a Swap
25.54 Actual Use of Derivatives
25.55 Quick Quiz
CHAPTER ORGANIZATION
25.1 Derivatives, Hedging, and Risk
25.2 Forward Contracts
25.4 Hedging
25.5 Interest Rate Futures Contracts

Pricing of Treasury Bonds
Pricing of Forward Contracts
Futures Contracts
Hedging in Interest Rate Futures

The Case of Zero Coupon Bonds
The Case of Two Bonds with the Same Maturity but with Different
Coupons
Duration
Matching Liabilities with Assets
25.7 Swaps Contracts

Interest Rate Swaps
Currency Swaps
Credit Default Swaps
Exotics
25-3
25.8 Actual Use of Derivatives
ANNOTATED CHAPTER OUTLINE
Slide 25.0 Chapter 25 Title Slide

Slide 25.1 Key Concepts and Skills
Slide 25.2 Chapter Outline
25.1. Derivatives, Hedging, and Risk
The value of a derivative asset is “derived” from an underlying

primary asset. Derivatives can be used to change an individual’s or
firm’s risk exposure.
25.2. Forward Contracts
Slide 25.3 Forward Contracts

Forward contract – agreement between a buyer (long) and a seller
(short) for future delivery of an asset at a price specified today
Forward price – price agreed upon today to be paid at a future date

when delivery occurs
Settlement date – date when delivery occurs and the forward price
is paid (received)
Lecture Tip: In a forward contract, both parties are legally bound

to execute the transaction in the future at the agreed-upon price,
but no money changes hands at the inception of the contract. Here
is an example to help explain this concept to students.
Suppose you want to buy a new Ford Mustang convertible as
soon as it becomes available. You contract with the dealer to pay a
specified price on a specified future date (the delivery date). In
essence, a private-market forward contract has been created. You
have a long position (buyer) in the underlying asset (Mustang) and
the Ford dealer has a short position (seller).
Now suppose that after the contract is signed, demand for the
car rises so that the market value of the car increases above the
agreed-upon price. You have a document that gives you the
right to buy the asset at below market prices, and the dealer is
obligated to sell at that price. The “long” position wins because
prices have increased.
25-4
Suppose on the other hand, the economy worsens and the

demand for cars decreases. This drives the market value of the car
lower. The dealer, however, has a contract that forces you to pay
the above market price. In this case, the “short” position wins
because prices have decreased.
What keeps either party from defaulting on the contract? This
question is a good lead-in to the discussion of futures, margin and
marking-to-market.
25.3. Futures Contracts
Slide 25.4 –
Slide 25.5 Futures Contracts
Futures contract – standardized forward contract traded only on an
exchange with gains and losses recognized on a daily basis
Slide 25.6 –
Slide 25.9 Daily Resettlement: An Example
Marking-to-market – process for daily recognizing gains and losses
Slide 25.10 Selected Futures Contracts

Typically, futures contracts are divided into two broad categories
- commodity contracts such as oil, gold, or wheat
- financial contracts such as T-bond or S&P 500
Slide 25.11 Futures Markets

Lecture Tip: So what are the major differences between an OTC
forward contract and an exchange traded futures contract?
Forward Futures
Customized Standard features (delivery date, size of
contract, quality of asset, etc.)
Search cost – use dealers No search cost – contact broker
Low liquidity High liquidity
Higher default risk – limited to large, Virtually no default risk
creditworthy institutions
No up-front or intermediate cash flows Initial margin requirements, daily marking-
to-market, margin calls
No Clearinghouse Clearinghouse that guarantees performance
Delivery normally occurs Majority of contracts offset, not delivered
25-5
Lecture Tip: How do we ensure that both parties fulfill their end of
the contract, particularly if there is a large price movement one
way or the other? The answer provides the main distinguishing
characteristic between straight forward contracts and futures
contracts. The only guarantees with a forward contract are the
fear of litigation if one party defaults and wanting to maintain a
good reputation.
Suppose instead of entering into a forward contract with the
dealer, you enter into a futures contract with the Mustang as the
underlying asset. In this instance, both parties would deposit
margin (or a good-faith deposit) with an independent third party.
Funds would then be transferred back and forth between your
account and the dealer’s account on a regular basis as the price of
the Mustang fluctuated. When it came time to buy the car, any gain
or loss would already be accounted for, thereby reducing the
likelihood of default.
Slide 25.12 Wall Street Journal Futures Price Quotes

Slide 25.13 Basic Futures Relationships
Settlement price – price at which contracts are marked-to-market
and determined by the settlement committee at each exchange,
may or may not equal the price at the last trade
Open interest – number of outstanding contracts
One problem with forward contracts is enforcing the agreement on

the delivery date. If the cash price on the delivery date is higher
than the agreed price, the seller has the incentive to default, and
vice versa. Futures contracts greatly reduce the risk of default
relative to forward contracts by:
1. Having an exchange clearinghouse take one side of every
transaction.
2. Requiring an initial and a maintenance margin.
3. Marking to market on a daily basis.
25.4. Hedging
Slide 25.14 Hedging

Slide 25.15 Hedging and Speculating: Example
Slide 25.16 Hedging: How many contracts?
Hedging is the process of reducing risk, whether it be the risk of
changing prices, currency fluctuations, or changes in interest rates.
25-6
Speculating is the opposite of hedging, which implies it is the

process of increasing risk.
Both hedgers and speculators are necessary for an active, liquid

derivatives market.
While forward and futures contracts can be used for speculative

purposes, the chapter focuses on the use of these derivative
securities to reduce risk. Either side of a forward or futures
contract can be used to hedge:
1. A short futures hedge involves selling a futures contract. Short

hedges are used when you will be making delivery of an asset at a
future date (e.g., a farmer anticipating a harvest of wheat) and wish
to minimize the risk of a drop in price.
2. A long futures hedge involves buying a futures contract. Long

hedges are used when you must purchase an asset at a future date
(e.g., a bakery with a demand for wheat) and wish to minimize the
risk of a rise in price.
Lecture Tip: It may be beneficial to demonstrate a futures hedge

and the potential payoffs for a soybean farmer who anticipates a
harvest of 100,000 bushels in September. Costs to produce the
soybeans are incurred long before the harvest, but the farmer is at
risk that the price of soybeans will fall before harvest time. To
reduce this risk, the farmer takes a short position (because he
wants to sell the soybeans) in the futures contract. This short
position offsets the long position that he already has in soybeans.
Futures contract terms are for 5,000 bushels, and the current
futures price is $4.50 per bushel. The farmer can lock in the
delivery price of soybeans at $4.50 for his harvest by shorting
(selling) 20 soybean futures contracts on June 1st. No cash changes
hands today, although margin is held in the farmer’s account. The
20 contracts represent delivery of 100,000 bushels. The cash flow
at delivery is $4.50(100,000) = $450,000
Date Closing Farmer Net
06/01 no money changes hands
06/10 4.60 pay 10,000 (-.1*100,000) -10,000
06/15 4.40 receive 20,000 (.2*100,000) +10,000
06/30 4.20 receive 20,000 +30,000
07/20 4.30 pay 10,000 +20,000
08/05 4.40 pay 10,000 +10,000
08/16 4.20 receive 20,000 +30,000
09/01 4.20
25-7
The farmer will deliver the soybeans and receive $4.20 per
bushel for 420,000 + 30,000 profit from the futures for a total cash
inflow of 450,000.
If a bumper crop occurs and the farmer harvests 120,000
bushels, the farmer will receive 450,000 for the first 100,000 and
then an addition 20,000*4.20 = 84,000 for the extra.
Suppose instead there is a poor harvest and the farmer only has
70,000 bushels. But, because of the short supply, the price is $4.75
per bushel. The farmer would realize a loss of 25,000
(.25*100,000) on the futures contracts and would receive
70,000(4.75) = 332,500 for the sale of the soybeans. His net profit
would be $307,500. As this illustrates, the farmer can only hedge
price risk, not quantity risk.
25.5. Interest Rate Futures Contracts
Slide 25.17 Interest Rate Futures Contracts

A. Pricing of Treasury Bonds
Slide 25.18 –
Slide 25.19 Pricing of Treasury Bonds
Recall the general expression for the value of a bond:
Bond value = present value of coupons + present value of par

Bond value = [C[1 – 1/(1+R)T] / R] + [FV / (1+R)T]
This formula assumes a flat yield curve. If this is not the case, then
each cash flow must be discounted at the rate specific to the timing
of the cash flow.
B. Pricing of Forward Contracts
Slide 25.20 Pricing of Forward Contracts

Slide 25.21 –
Slide 25.22 Pricing of Forward Contracts: Example
With the forward contract, you are agreeing to purchase the bond
at a specified point in the future. The value of the bond at that time
is just the present value of the subsequent cash flows. This price
can then be discounted to the present to find the value at time 0.
C. Futures Contracts
25-8
Slide 25.23 Pricing of Futures Contracts

Futures contracts are priced similarly to forwards, with the
exception of the daily resettlement.
D. Hedging in Interest Rate Futures
Slide 25.24 Hedging in Interest Rate Futures

25.6. Duration Hedging
Slide 25.25 –
Slide 25.26 Duration Hedging
Duration is a measure of interest rate (i.e., price) risk.
A. The Case of Zero Coupon Bonds
Long term bonds are more sensitive to changes in interest rates.
B. The Case of Two Bonds with the Same Maturity but with Different
Coupons
Low coupon bonds are more sensitive to changes in interest rates.
C. Duration
Slide 25.27 Duration Formula

Slide 25.28 –
Slide 25.29 Calculating Duration: Example
Slide 25.30 Duration
In 1938, Frederick MaCaulay defined the duration of an asset with

cash payments (C1, ... ,CT) as the weighted average maturity of
an asset stated in terms of present values:
 Ct 
 
 (1 + R )t 
Duration =  t  
T
t
T 
Ct 

t =1
 
 t 
t =1  (1 + Rt ) 
25-9
Hicks (see also Hopewell and Kaufman [1974]) independently

developed the same measure in 1939 and noted that it represented
the price elasticity of an asset with respect to a change in the level
of interest rates. The relationship between changes in interest rate,
changes in bond prices, and duration is:
 P   R − R0 
1 + 1  = − Duration 1 
 P0   1 + R0 
Lecture Tip: You may want to show students that Excel has a built
in function for finding duration. It is =duration(…).
D. Matching Liabilities with Assets
By matching the duration of financial assets and liabilities, a

change in interest rates has the same impact on the value of the
assets and liabilities, leaving the value of equity unchanged.
Duration as a measure of price elasticity is important in many

portfolio management applications. In banking, matching the
duration of financial assets and liabilities is referred to as "asset-
liability management." In insurance, duration hedging is used in
"insulating" a portfolio of assets and liabilities against changes in
interest rates. The basic concept has applications in corporate
finance as well. Following is an example of hedging interest rate
risk using futures contracts.
Example of an Interest-rate Futures Hedge

Your firm has just leased a downtown hotel to a national hotel
chain. The lessee has agreed to pay your firm $10M per year for
the next 20 years. You can hedge the risk of a rise in inflation (and
hence a fall in the value of the lease contract) over this period by
forming a short hedge in the T-bond futures market.
To keep the analysis simple, assume that a 10% discount rate

applies to both the lease receipts and the T-bonds. The present
value of the 20-year lease contract is $85.136M. The duration of
the lease contract is calculated as:
Year CF PV (r=10%) PV Weight Year × Wt

1 10M 10M/1.1 = 9.0909M 9.0909/85.1356 = .1068 1 × .1068 = .1068
2 10M 10M/1.12 = 8.2645M 8.2645/85.1356 = .0971 2 × .0971 = .1941
. . .
. . .
20
20 10M 10/1.1 =1.4864M 1.4864/85.1356 = .0175 20 × .0175 = .3492
Total PV = 85.1356M Duration = 7.508 years
25-10
A Short Futures Hedge

Suppose there is a futures contract trading on an exchange based
on 12-year T-Bonds with 10% coupons selling at par. The duration
of the T-Bond is 7.495 years.
An offsetting short-futures position in the T-Bond can hedge the

interest rate risk of the expected future lease receipts. The firm can
sell $85.1M worth of T-Bond (85.1 contracts @$100,000 each)
using futures contracts. This short position has a duration of 7.495
years. The amount and duration of the financial asset (the lease
receipts) are very close to those of the financial liability (the
futures obligation). Consequently, the hedged position should be
relatively insensitive to changes in interest rates.
Suppose the interest rate increases from 10% to 12%. The effects
on the long (lease) and short (T-Bond futures) positions are as
follows:
Lease Receipts T-Bond Futures Asset – Liabilities

Value at r = 10% $85.136M $85.136M $0.000M
Value at r = 12% $74.694M $74.588M $0.106M
Change in value $10.442M $10.548M $0.106M
When interest rate increases to 12%, your firm loses on the lease
agreement, which falls in value by $10.442M to $74.694M. The
value of the futures contracts obligation also decreases (by
$10.548M to $74.588M). The value of your firm's net position
actually increases by $0.106M. In terms of reducing risk, the
change in value on the net position ($0.106M) is substantially
smaller than the change in value of the unhedged position
($10.442M).
This example was not a perfect hedge for two reasons. First, the
duration of the lease and T-bond futures contracts were not
identical. Second, matching duration only provides a perfect hedge
if the change in interest rate is infinitesimal and the yield curve is
flat.
The duration of the lease and the T-bond also change when interest
rate changes. The new duration for the lease is 7.020 years and for
the T-bond it is 7.185 years when interest rate is 12%. Notice that
the difference in duration widens at the new interest rate. To
minimize the exposure of the net position, you can close the
25-11
existing futures contract and sell $74.694M of new futures

contracts of 12% T-Bond with duration = 6.938 years. To hedge
interest rate risk effectively you must rebalance your positions
when the interest rate changes.
Lecture Tip: Duration and Hedging

1. Duration and the Yield Curve
Ideally, the yield curve is based on pure discount bonds. The term
structure of interest rates refers to the current spot rates of interest
on pure discount bonds that differ only in their maturity. In
practice, the difficulty lies in inferring the term structure of pure
discount bonds from the available selection of coupon-bearing
bonds. Duration provides a surrogate for the maturity of a pure
discount bond because the duration of a pure discount bond is its
maturity.
2. The Effectiveness of Hedging Risk using Duration Matching
While duration has a wide following in the practitioners' literature,
it has often been criticized in academic circles. Duration as a
measure of price elasticity suggests a linear relationship between
duration and return. Several studies (e.g., Gultekin and Rogalski
[1976]) have demonstrated that duration and return are not
linearly related for discrete bond price changes. Gultekin and
Rogalski [1984] and Ingersol, Skelton, and Well [1977] found that
Macaulay's duration performed no better than simple maturity in
explaining bond returns. Both of these latter studies suggest
multiple factor models to explain the price volatility of bonds in
response to changes in interest rates (see Richard [1978] and
Schaefer and Schwartz [1978]). Cox, Ingersol, and Ross [1979]
derive a general measure of price volatility based on a model of
the term structure which assumes that interest rates change
through a stochastic process.
25.7. Swaps Contracts
Slide 25.31 Swaps Contracts

Swaps are arrangements between two counterparties to exchange
cash flows over time. Thus, swaps are essentially a series of
forward contracts.
Slide 25.32 The Swap Bank

The swap bank acts as either a broker (matching counterparties) or
dealer (serving as one of the counterparties).
A. Interest Rate Swaps

25-12
Slide 25.33 –
Slide 25.41 An Example of an Interest Rate Swap
Just as two companies can agree to exchange currencies at specific

future dates, they can also agree to exchange the cash flows
associated with respective loan agreements.
Interest rate swaps are generally used to convert a fixed rate

obligation to a floating rate obligation, or vice versa, depending on
the needs of the company.
Only the net interest payment is exchanged since we are dealing

with one currency.
B. Currency Swaps
Slide 25.42 –
Slide 25.48 An Example of a Currency Swap
Two firms agree to exchange a specific amount of one currency for

a specific amount of another currency at specific future dates.
Lecture Tip: The following example illustrates that a currency

swap is essentially a “parallel loan.”
Example: Two multinational companies with foreign projects
need to obtain financing. Company A is based in England and has
a U.S. project. Company B is based in the U.S. and has a British
project.
1. Both firms want to avoid exchange rate fluctuations.
2. Both firms receive currency for investment at time zero and
repay loans as funds are generated by the foreign project.
3. Both firms could avoid exchange rate fluctuations if they
arrange loans in the country of the project. Funds generated in
England for the U.S. company (B) would be in pounds and
repayment would be in pounds. The opposite would be true for the
British company.
4. Both firms can borrow cheaper in their home countries than
they can in the country where the project originates.
The firms arrange loans for the initial investment in their home
currency and then use the proceeds from the project, converted to
the home currency through a swap agreement, to repay the loan.
Cash flows for the swap: Assume a fixed exchange rate of $2
per £1, a fixed interest rate of 10% for both firms, and a four-year
loan.
25-13
Corporate Finance 11th Edition Ross Solutions Manual
Year 0 1 2 3 4
Company A -£100,000 -$20,000 -$20,000 -$20,000 -$20,000
+$200,000 +£10,000 +£10,000 +£10,000 +£10,000
Company B -$200,000 -£10,000 -£10,000 -£10,000 -£10,000
+£100,000 +$20,000 +$20,000 +$20,000 +$20,000
These cash flows are the same as those for a parallel loan. The
firms have effectively fixed the exchange rate for the $200,000
(£100,000) loan and enough of the cash flows to repay the loans in
the home currencies.
C. Credit Default Swaps
Slide 25.49 Credit Default Swaps

A Credit Default Swap (CDS) effectively serves as insurance
against the default of a bond. The first counterparty (protection
buyer) pays a periodic CDS spread to the second counterparty
(protection seller) in exchange for covering the full bond value
should a default occur.
The terms and structure seem clear; however, the lack of an

organized exchange creates significant counterparty risk.
Lecture Tip: Obviously, a discussion of Lehmann Brothers and

AIG would be particularly relevant at this point.
D. Exotics
Slide 25.50 Variations of Basic Swaps
Slide 25.51 –
Slide 25.52 Risks of Interest Rate and Currency Swaps
Slide 25.53 Pricing a Swap

25.8. Actual Use of Derivatives
Slide 25.54 Actual Use of Derivatives

The use of derivatives, particularly interest rate and currency, is
widespread, but may be primarily concentrated in large, publicly-
held corporations.
Slide 25.55 Quick Quiz

25-14
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Chapter 25 - Derivatives and Hedging Risk

Visit TestBankBell.com to get complete for all chapters

25.1 Key Concepts and Skills

25.41 An Example of an Interest Rate Swap

25.1 Derivatives, Hedging, and Risk

25.2 Forward Contracts

25.3 Futures Contracts

25.5 Interest Rate Futures Contracts

25.6 Duration Hedging

25.7 Swaps Contracts

25.8 Actual Use of Derivatives

ANNOTATED CHAPTER OUTLINE

Slide 25.0 Chapter 25 Title Slide

The value of a derivative asset is “derived” from an underlying

25.2. Forward Contracts

Slide 25.3 Forward Contracts

Forward price – price agreed upon today to be paid at a future date

Lecture Tip: In a forward contract, both parties are legally bound

Suppose on the other hand, the economy worsens and the

25.3. Futures Contracts

Marking-to-market – process for daily recognizing gains and losses

Slide 25.10 Selected Futures Contracts

Slide 25.11 Futures Markets

Slide 25.12 Wall Street Journal Futures Price Quotes

Open interest – number of outstanding contracts

One problem with forward contracts is enforcing the agreement on

Slide 25.14 Hedging

Speculating is the opposite of hedging, which implies it is the

Both hedgers and speculators are necessary for an active, liquid

While forward and futures contracts can be used for speculative

1. A short futures hedge involves selling a futures contract. Short

2. A long futures hedge involves buying a futures contract. Long

Lecture Tip: It may be beneficial to demonstrate a futures hedge

25.5. Interest Rate Futures Contracts

Slide 25.17 Interest Rate Futures Contracts

Bond value = present value of coupons + present value of par

B. Pricing of Forward Contracts

Slide 25.20 Pricing of Forward Contracts

Slide 25.23 Pricing of Futures Contracts

D. Hedging in Interest Rate Futures

Slide 25.24 Hedging in Interest Rate Futures

A. The Case of Zero Coupon Bonds

Long term bonds are more sensitive to changes in interest rates.

Low coupon bonds are more sensitive to changes in interest rates.

Slide 25.27 Duration Formula

In 1938, Frederick MaCaulay defined the duration of an asset with

Hicks (see also Hopewell and Kaufman [1974]) independently

D. Matching Liabilities with Assets

By matching the duration of financial assets and liabilities, a

Duration as a measure of price elasticity is important in many

Example of an Interest-rate Futures Hedge

To keep the analysis simple, assume that a 10% discount rate

Year CF PV (r=10%) PV Weight Year × Wt

A Short Futures Hedge

An offsetting short-futures position in the T-Bond can hedge the

Lease Receipts T-Bond Futures Asset – Liabilities

existing futures contract and sell $74.694M of new futures

Lecture Tip: Duration and Hedging

25.7. Swaps Contracts

Slide 25.31 Swaps Contracts

Slide 25.32 The Swap Bank

A. Interest Rate Swaps