2
Section 1.1. The basics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5
Section 1.2. Models and derivatives markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Section 1.3. Using derivatives the right way . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Section 1.4. Nineteen steps to using derivatives the right way . . . . . . . . . . . . . . . . . . . . 19
Literature Note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Figure 1.1. Payoff of derivative which pays the 10m times the excess of the square of the
decimal interest rate over 0.01. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24
Figure 1.2. Hedging with forward contract. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Panel A. Income to unhedged exporter. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Panel B. Forward contract payoff . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Panel C. Hedged firm income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
Figure 1.3. Payoff of share and call option strategies . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Figure 1.3.A. Payoff of buying one share of Amazon.com at $75 . . . . . . . . . . . 26
Figure 1.3.B. Payoff of buying a call option on one share of Amazon.com with
exercise price of $75 for a premium of $10. . . . . . . . . . . . . . . . . . . . . . . 26
Chapter 1: Introduction
August 5, 1999
Ren M. Stulz 1997, 1999
Chapter 2, page 1
Throughout history, the weather has determined the fate of nations, businesses, and
individuals. Nations have gone to war to take over lands with a better climate. Individuals have
starved because their crops were made worthless by poor weather. Businesses faltered because the
goods they produced were not in demand as a result of unexpected weather developments. Avoiding
losses due to inclement weather was the dream of poets and the stuff of science fiction novels  until
it became the work of financial engineers, the individuals who devise new financial instruments and
strategies to enable firms and individuals to better pursue their financial goals. Over the last few years,
financial products that can be used by individuals and firms to protect themselves against the financial
consequences of inclement weather have been developed and marketed. While there will always be
sunny and rainy days, businesses and individuals can now protect themselves against the financial
consequences of unexpectedly bad weather through the use of financial instruments. The introduction
of financial instruments that help firms and individuals to deal with weather risks is just one example
of the incredible growth in the availability of financial instruments for managing risks. Never in the
course of history have firms and individuals been able to mitigate the financial impact of risks as
effectively through the use of financial instruments as they can now.
There used to be stocks and bonds and not much else. Knowing about stocks and bonds was
enough to master the intricacies of financial markets and to choose how to invest ones wealth. A
manager had to know about the stock market and the bond market to address the problems of his
firm. Over the last thirty years, the financial instruments available to managers have become too
numerous to count. Not only can managers now protect their firms against the financial consequences
of bad weather, there is hardly a risk that they cannot protect their firm against if they are willing to
1
The American Heritage Dictionary of the English Language, Third Edition (1982),
Houghton Mifflin Company, Boston.
Chapter 2, page 2
pay the appropriate price or a gamble that they cannot take through financial instruments. Knowing
stocks and bonds is therefore not as useful as it used to be. Attempting to know all existing financial
instruments is no longer feasible. Rather than knowing something about a large number of financial
instruments, it has become critical for managers to have tools that enable them to evaluate which
financial instruments  existing or to be invented  best suit their objectives. As a result of this
evolution, managers and investors are becoming financial engineers.
Beyond stocks and bonds, there is now a vast universe of financial instruments called
derivatives. In chemistry, a derivative is a compound derived from another and containing essential
elements of the parent substance.
1
Derivatives in finance work on the same principle as in chemistry.
They are financial instruments whose payoffs are derived from something else, often but not
necessarily another financial instrument. It used to be easier to define the world of derivatives. Firms
would finance themselves by issuing debt and equity. Derivatives would then be financial instruments
whose payoffs would be derived from debt and equity. For instance, a call option on a firms stock
gives its owner the right to buy the stock at a given price, the exercise price. The call option payoff
is therefore derived from the firms stock. Unfortunately, defining the world of derivatives is no
longer as simple. Nonfinancial firms now sell derivatives to finance their activities. There are also
derivatives whose value is not derived from the value of financial instruments directly. Consider a
financial instrument of the type discussed in chapter 18 that promises its holder a payment equal to
ten million dollars times the excess of the square of the decimal interest rate over 0.01 in 90 days
where the interest rate is the London Interbank Offer Rate (LIBOR) on that day as reported by the
Chapter 2, page 3
British Bankers Association. Figure 1.1. plots the payoff of that financial instrument. If the interest
rate is 10%, this instrument therefore pays nothing, but if the interest rate is 20%, this instrument pays
$300,000 (i.e., 0.20 squared minus 0.01 times ten million). Such an instrument does not have a value
that depends directly on a primitive asset such as a stock or a bond.
Given the expansion of the derivatives markets, it is hard to come up with a concise definition
of derivatives that is more precise than the one given in the previous paragraph. A derivative is a
financial instrument with contractually specified payoffs whose value is uncertain when the contract
is initiated and which depend explicitly on verifiable prices and/or quantities. A stock option is a
derivative because the payoff is explicitly specified as the right to receive the stock in exchange of the
exercise price. With this definition of a derivative, the explicit dependence of payoffs on prices or
quantities is key. It distinguishes derivatives from common stock. The payoffs of a common stock are
the dividend payments. Dividends depend on all sorts of things, but this dependence is not explicit.
There is no formula for a common stock that specifies the size of the dividend at one point in time.
The formula cannot depend on subjective quantities or forecasts of prices: The payoff of a derivative
has to be such that it can be determined mechanically by anybody who has a copy of the contract.
Hence, a third party has to be able to verify that the prices and/or quantities used to compute the
payoffs are correct. For a financial instrument to be a derivative, its payoffs have to be determined
in such a way that all parties to the contract could agree to have them defined by a mathematical
equation that could be enforced in the courts because its arguments are observable and verifiable.
With a stock option, the payoff for the option holder is receiving the stock in exchange of paying the
exercise price. The financial instrument that pays $300,000 if the interest rate is 20% is a derivative
by this definition since the contractually specified payoff in ninety days is given by a formula that
Chapter 2, page 4
depends on a rate that is observable. A judge could determine the value of the contracts payoff by
determining the appropriate interest rate and computing the payoff according to the formula. A share
of IBM is not a derivative and neither is a plain vanilla bond issued by IBM. With this definition, the
variables that determine the payoffs of a derivative can be anything that the contracting parties find
useful including stock prices, bond prices, interest rates, number of houses destroyed by hurricanes,
gold prices, egg prices, exchange rates, and the number of individual bankruptcies within a calendar
year in the U.S.
Our definition of a derivative can be used for a weather derivative. Consider a financial
contract that specifies that the purchaser will receive a payment of one hundred million dollars if the
temperature at La Guardia at noon exceeds 80 degrees Fahrenheit one hundred days or more during
a calendar year. If one thinks of derivatives only as financial instruments whose value is derived from
financial assets, such a contract would not be called a derivative. Such a contract is a derivative with
our definition because it specifies a payoff, one hundred million dollars, that is a function of an
observable variable, the number of days the temperature exceeds 80 degrees at La Guardia at noon
during a calendar year. It is easy to see how such a weather derivative would be used by a firm for
risk management. Consider a firm whose business falls dramatically at high temperatures. Such a firm
could hedge itself against weather that is too hot by purchasing such a derivative. Perhaps the
counterparty to the firm would be an ice cream manufacturer whose business suffers when
temperatures are low. But it might also be a speculator who wants to make a bet on the weather.
At this point, there are too many derivatives for them to be counted and it is beyond
anybodys stamina to know them all. In the good old days of derivatives  late 1970s and early 1980s
 a responsible corporate manager involved in financial matters could reasonably have detailed
Chapter 2, page 5
knowledge of all economically relevant derivatives. This is no longer possible. At this point, the key
to success is being able to figure out which derivatives are appropriate and how to use them given
ones objectives rather than knowing a few of the many derivatives available. Recent history shows
that this is not a trivial task. Many firms and individuals have faced serious problems using derivatives
because they were not well equipped to evaluate their risks and uses. Managers that engaged in
poorly thought out derivatives transactions have lost their jobs, but not engaging in derivatives
transactions is not an acceptable solution. While derivatives used to be the province of finance
specialists, they are now intrinsic to the success of many businesses and businesses that do not use
them could generally increase their shareholders wealth by using them. A finance executive who
refuses to use derivatives because of these difficulties is like a surgeon who does not use a new
lifesaving instrument because some other surgeon made a mistake using it.
The remainder of this chapter is organized as follows. We discuss next some basic ideas
concerning derivatives and risk management. After explaining the role of models in the analysis of
derivatives and risk management, we discuss the steps one has to take to use derivatives correctly.
We then turn to an overview of the book.
Section 1.1. The basics.
Forward contracts and options are often called plain vanilla derivatives because they are
the simplest derivatives. A forward contract is a contract where no money changes hands when the
contract is entered into but the buyer promises to purchase an asset or a commodity at a future date,
the maturity date, at a price fixed at origination of the contract, the forward price, and where the
seller promises to deliver this asset or commodity at maturity in exchange of the agreed upon price.
Chapter 2, page 6
An option gives its holder a right to buy an asset or a commodity if it is a call option or to sell an
asset or a commodity if it is a put option at a price agreed upon when the option contract is written,
the exercise price. Predating stocks and bonds, forward contracts and options have been around a
long time. We will talk about them throughout the book. Lets look at them briefly to get a sense of
how derivatives work and of how powerful they can be.
Consider an exporter who sells in Europe. She will receive one million euros in ninety days.
The dollar value of the payment in ninety days will be one million times the dollar price of the euro.
As the euro becomes more valuable, the exporter receives more dollars. The exporter is long in the
euro, meaning that she benefits from an increase in the price of the euro. Whenever cash flow or
wealth depend on a variable  price or quantity  that can change unexpectedly for reasons not under
our control, we call such a variable a risk factor. Here, the dollar price of a euro is a risk factor. In
risk management, it is always critical to know what the risk factors are and how their changes affect
us. The sensitivity of cash flow or wealth to a risk factor is called the exposure to that risk factor.
The change in cash flow resulting from a change in a risk factor is equal to the exposure times the
change in the risk factor. Here, the risk factor is the dollar price of the euro and the cash flow impact
of a change in the dollar price of the euro is one million times the change in the price of the euro. The
exposure to the euro is therefore one million euros. We will see that measuring exposure is often
difficult. Here, however, it is not.
In ninety days, the exporter will want to convert the euros into dollars to pay her suppliers.
Lets assume that the suppliers are due to receive $950,000. As long as the price of the euro in ninety
days is at least 95 cents, everything will be fine. The exporter will get at least $950,000 and therefore
can pay the suppliers. However, if the price of the euro is 90 cents, the exporter receives $900,000
Chapter 2, page 7
dollars and is short $50,000 to pay her suppliers. In the absence of capital, she will not be able to pay
the suppliers and will have to default, perhaps ending the business altogether. A forward contract
offers a solution for the exporter that eliminates the risk of default. By entering a forward contract
with a maturity of 90 days for one million euros, the exporter promises to deliver one million euros
to the counterparty who will in exchange pay the forward price per euro times one million. For
instance, if the forward price per euro is 99 cents, the exporter will receive $990,000 in ninety days
irrespective of the price of the euro in ninety days. With the forward contract, the exporter makes
sure that she will be able to pay her suppliers.
Panel A of figure 1.2. shows the payoff of the position of the exporter in the cash market, i.e.,
the dollars the exporter gets for the euros it sells on the cash market if she decides to use the cash
market to get dollars in 90 days. Panel B of figure 1.2. shows the payoff of a short position in the
forward contract. A short position in a forward contract benefits from a fall in the price of the
underlying. The underlying in a forward contract is the commodity or asset one exchanges at
maturity of the forward contract. In our example, the underlying is the euro. The payoff of a short
position is the receipt of the forward price per unit times the number of units sold minus the value of
the price of the underlying at maturity times the number of units delivered. By selling euros through
a forward contract, our exporter makes a bigger profit from the forward contract if the dollar price
of the euro falls more. If the euro is at $1.1 at maturity, our exporter agreed to deliver euros worth
$1.1 per unit at the price of $0.99, so that she loses $0.11 per unit or $110,000 on the contract. In
contrast, if the euro is at $0.90 at maturity, the exporter gets $0.99 per unit for something worth $0.9
per unit, thereby gaining $90,000 on the forward contract. With the forward contract, the long , i.e.,
the individual who benefits from an increase in the price of the underlying  receives the underlying
Chapter 2, page 8
at maturity and pays the forward price. His profit is therefore the cash value of the underlying at
maturity minus the forward price times the size of the forward position. The third panel of Figure
1.1., panel C, shows how the payoff from the forward contract added to the payoff of the cash
position of the exporter creates a riskfree position. A financial hedge is a financial position that
decreases the risk resulting from the exposure to a risk factor. Here, the cash position is one million
euros, the hedge is the forward contract. In this example, the hedge is perfect  it eliminates all the
risk so that the hedged position, defined as the cash position plus the hedge, has no exposure to the
risk factor.
Our example has three important lessons. First, through a financial transaction, our exporter
can eliminate all her risk without spending any cash to do so. This makes forward contracts
spectacularly useful. Unfortunately, life is more complicated. Finding the best hedge is often difficult
and often the best hedge is not a perfect hedge.
Second, to eliminate the risk of the hedged position, one has to be willing to make losses on
derivatives positions. Our exporter takes a forward position such that her hedged cash flow has no
uncertainty  it is fixed. When the euro turns out to be worth more than the forward price, the
forward contract makes a loss. This is the case when the price of the euro is $1.1. This loss exactly
offsets the gain made on the cash market. It therefore makes no sense whatsoever to consider
separately the gains and losses of derivatives positions from the rest of the firm when firms use
derivatives to hedge. What matters are the total gain and loss of the firm.
Third, when the exporter enters the forward contract, she agrees to sell euros at the forward
price. The counterparty in the forward contract therefore agrees to buy euros at the forward price.
No money changes hands except for the agreed upon exchange of euros for dollars. Since the
Chapter 2, page 9
counterparty gets the mirror image of what the exporter gets, if the forward contract has value at
inception for the exporter in that she could sell the forward contract and make money, it has to have
negative value for the counterparty. In this case, the counterparty would be better off not to enter the
contract. Consequently, for the forward contract to exist, it has to be that it has no value when
entered into. The forward price must therefore be the price that insures that the forward contract has
no value at inception.
Like the forward contract, many derivatives have no value at inception. As a result, a firm can
often enter a derivatives contract without leaving any traces in its accounting statements because no
cash is used and nothing of value is acquired. To deal with derivatives, a firm has to supplement its
conventional accounting practices with an accounting system that takes into account the risks of
derivatives contracts. We will see how this can be done.
Lets now consider options. The bestknown options are on common stock. Consider a call
option on Amazon.com. Suppose the current stock price is $75 and the price of a call option with
exercise price of $75 is $10. Such an option gives the right to its holder to buy a fixed number of
shares of Amazon.com stock at $75. Options differ as to when the right can be exercised. With
European options, the right can only be exercised at maturity. In contrast, American options are
options that can be exercised at maturity and before. Consider now an investor who believes that
Amazon.com is undervalued by the market. This individual could buy Amazon.com shares and could
even borrow to buy such shares. However, this individual might be concerned that there is some
chance he will turn out to be wrong and that something bad might happen to Amazon.com. In this
case, our investor would lose part of his capital. If the investor wants to limit how much of his capital
he can lose, he can buy a call option on Amazon.com stock instead of buying Amazon.com shares.
Chapter 2, page 10
In this case, the biggest loss our investor would make would be to lose the premium he paid to
acquire the call option. Figure 1.3. compares the payoff for our investor of holding Amazon.com
shares and of buying a call option instead at maturity of the option assuming it is a European call
option. If the share price falls to $20, the investor who bought the shares loses $55 per share bought,
but the investor who bought the call option loses only the premium paid for the call of $10 per share
since he is smart enough not to exercise a call option that requires him to pay $75 for shares worth
$20. If the share price increases to $105, the investor who bought the shares gains $30 per share, but
the investor who bought options gains only $20 since he gains $30 per share when he exercises the
call option but had paid a premium of $10 per share. Our investor could have used a different
strategy. He could have bought Amazon.com shares and protected himself against losses through the
purchase of put options. A put option on a stock gives the right to sell shares at a fixed price. Again,
a put option can be a European or an American option.
With our example of a call option on Amazon.com, the investor has to have cash of $75 per
share bought. He might borrow some of that cash, but then his ability to invest depends on his credit.
To buy a call, the investor has to have cash of $10. Irrespective of which strategy the investor uses,
he gets one dollar for each dollar that Amazon.com increases above $75. If the share price falls below
$75, the option holder loses all of the premium paid but the investor in shares loses less as long as the
stock price does not fall by $10 or more. Consider an investor who is limited in his ability to raise
cash and can only invest $10. This investor can get the same gain per dollar increase in the stock price
as an investor who buys a share if he buys the call. If this investor uses the $10 to buy a fraction of
a share, he gets only $0.13 per dollar increase in the share price. To get a gain of one dollar from a
one dollar increase in the share price, our investor with $10 would have to borrow $65 to buy one
Chapter 2, page 11
share. In other words, he would have to borrow $6.5 for each dollar of capital. Option strategies
therefore enable the investor to lever up his resources without borrowing explicitly. The same is true
for many derivatives strategies. This implicit leverage can make the payoff of derivatives strategies
extremely volatile. The option strategy here is more complicated than a strategy of borrowing $65
to buy one share. This is because the downside risk is different between the borrowing strategy and
the option strategy. If the stock price falls to $20, the loss from the call strategy is $10 but the loss
from the borrowing strategy is $55. The option payoff is nonlinear. The gain for a one dollar increase
in the share price from $75 is not equal to minus the loss for a one dollar decrease in the share price
from $75. This nonlinearity is typical of derivatives. It complicates the analysis of the pricing of these
financial instruments as well as of their risk.
Call and put options give their holder a right. Anybody who has the right but not the
obligation to do something will choose to exercise the right to make himself better off. Consequently,
a call option is never exercised if the stock price is below the exercise price and a put option is never
exercised if the stock price is above the exercise price. Whoever sells an option at initiation of the
contract is called the option writer. The call option writer promises to deliver shares for the exercise
price and the put option writer promises to receive shares in exchange of the exercise price. When
an option is exercised, the option writer must always deliver something that is worthwhile. For the
option writer to be willing to deliver something worthwhile upon exercise, she must receive cash
when she agrees to enter the option contract. The problem is then to figure out how much the option
writer should receive to enter the contract.
Chapter 2, page 12
Section 1.2. Models and derivatives markets.
To figure out the price of an option, one has to have a model. To figure out whether it is
worthwhile to buy an option to hedge a risk, one has to be able to evaluate whether the economic
benefits from hedging the risk outweigh the cost from purchasing the option. This requires a model
that allows us to quantify the benefits of hedging. Models therefore play a crucial role in derivatives
and risk management. Models are simplified representations of reality that attempt to capture what
is essential. One way to think of models is that they are machines that allow us to see the forest rather
than only trees. No model is ever completely right because every model always abstracts from some
aspects of the real world. Since there is no way for anybody to take into account all the details of the
real world, models are always required to guide our thinking. It is easy to make two mistakes with
models. The first mistake is to think that a model is unrealistic because it misses some aspect of the
real world. Models do so by necessity. The key issue is not whether models miss things, but rather
whether they take enough things into account that they are useful. The second mistake is to believe
that if we have a model, we know the truth. This is never so. With a good model, one knows more
than with a bad model. Good models are therefore essential. Things can still go wrong with good
models because no model is perfect.
Stock options were traded in the last century and much of this century without a satisfactory
model that allowed investors and traders to figure out a price for these options. Markets do not have
to have a model to price something. To obtain a price, an equilibrium for a product where demand
equals supply is all that is required. Operating without a model is like flying a plane without
instruments. The plane can fly, but one may not get where one wants to go. With options, without
a model, one cannot quantify anything. One can neither evaluate a market price nor quantify the risk
Chapter 2, page 13
of a position. Lack of a model to price options was therefore a tremendous impediment to the growth
of the option market. The lack of a model was not the result of a lack of trying. Even Nobel
prizewinners had tried their hand at the problem. People had come up with models, but they were just
not very useful because to use them, one had to figure out things that were not observable. This lasted
until the early 1970s. At that time, two financial economists in Boston developed a formula that
revolutionized the field of options and changed markets for derivatives forever. One, Fischer Black,
was a consultant. The other one, Myron Scholes, was an assistant professor at MIT who had just
earned a Ph.D. in finance from the University of Chicago. These men realized that there was a trading
strategy that would yield the same payoff as an option but did not use options. By investing in stocks
and bonds, one could obtain the same outcome as if one had invested in options. With this insight and
the help of a third academic, Robert Merton, they derived a formula that was instantly famous 
except with the editors of academic journals who, amazingly, did not feel initially that it was
sufficiently useful to be publishable. This formula is now called the BlackScholes formula for the
pricing of options. With this formula, one could compute option prices using only observable
quantities. This formula made it possible to assess the risk of options as well as the value of portfolios
of options.
There are few achievements in social sciences that rival the BlackScholes formula. This
formula is tremendously elegant and represents a mathematical tourdeforce. At the same time, and
more importantly, it is so useful that it has spawned a huge industry. Shortly after the option pricing
formula was discovered, the Chicago Board of Trade started an options exchange. Business on this
exchange grew quickly because of the option pricing formula. Traders on the exchange would have
calculators with the formula programmed in them to conduct business. When Fischer Black or Myron
Chapter 2, page 14
Scholes would show up at the exchange, they would receive standing ovations because everybody
knew that without the BlackScholes formula, business would not be what it was.
The world is risky. As a result, there are many opportunities for trades to take place where
one party shifts risks to another party through derivatives. These trades must be mutually beneficial
or otherwise they would not take place. The purchaser of a call option wants to benefit from stock
price increases but avoid losses. He therefore pays the option writer to provide a hedge against
potential losses. The option writer does so for appropriate compensation. Through derivatives,
individuals and firms can trade risks and benefit from these trades. Early in the 1970s, this trading of
risks took place through stock options and forward transactions. However, this changed quickly. It
was discovered that the BlackScholes formula was useful not only to price stock options, but to
price any kind of financial contract that promises a payoff that depends on a price or a quantity.
Having mastered the BlackScholes formula, one could price options on anything and everything.
This meant that one could invent new instruments and find their value. One could price exotic
derivatives that had little resemblance to traditional options. Exotic derivatives are all the derivatives
that are not plain vanilla derivatives or cannot be created as a portfolio of plain vanilla derivatives.
The intellectual achievements involved in the pricing of derivatives made possible a huge industry.
Thirty years ago, the derivatives industry had no economic importance. We could produce countless
statistics on its current importance. Measuring the size of the derivatives industry is a difficult
undertaking. However, the best indicator of the growth and economic relevance of this industry is
that observers debate whether the derivatives markets are bigger and more influential than the
markets for stocks and bonds and often conclude that they are.
Because of the discovery of the BlackScholes formula, we are now in a situation where any
Chapter 2, page 15
type of financial payoff can be obtained at a price. If a corporation would be better off receiving a
large payment in the unlikely event that Citibank, Chase, and Morgan default in the same month, it
can go to an investment bank and arrange to enter the appropriate derivatives contract. If another
corporation wants to receive a payment which is a function of the square of the yen/dollar exchange
rate if the volatility of the S&P500 exceeds 35% during a month, it can do so. There are no limits to
the type of financial contracts that can be written. However, anybody remembers what happened in
their youth when suddenly their parents were not watching over their shoulders. Without limits, one
can do good things and one can do bad things. One can create worthwhile businesses and one can
destroy worthwhile businesses. It is therefore of crucial importance to know how to use derivatives
the right way.
Section 1.3. Using derivatives the right way.
A corporate finance specialist will see new opportunities to take positions in derivatives all
the time. He will easily think of himself as a master of the universe, knowing which instruments are
too cheap, which are too expensive. As it is easy and cheap to take positions in derivatives, this
specialist can make dramatic changes in the firms positions in instants. With no models to measure
risks, he can quickly take positions that can destroy the firm if things go wrong. Not surprisingly,
therefore, some firms have made large losses on derivatives and some firms have even disappeared
because of derivatives positions that developed large losses.
The first thing to remember, therefore, is that there are few masters of the universe. For every
corporate finance specialist who thinks that a currency is overvalued, there is another one who thinks
with the same amount of conviction that currency is undervalued. It may well be that a corporate
Chapter 2, page 16
finance specialist is unusually good at forecasting exchange rates, but typically, that will not be the
case. To beat the market, one has to be better than the investors who have the best information  one
has to be as good as George Soros at the top of his game. This immediately disqualifies most of us.
If mutual fund managers whose job it is to beat the market do not do so on average, why could a
corporate finance specialist or an individual investor think that they have a good enough chance of
doing so that this should direct their choice of derivatives positions? Sometimes, we know something
that has value and should trade on it. More often, though, we do not.
A firm or an individual that take no risks hold Tbills and earn the Tbill rate. Rockfeller had
it right when he said that one cannot get rich by saving. If one is to become rich, one has to take risks
to exploit valuable opportunities. Valuable opportunities are those where we have a comparative
advantage in that they are not as valuable to others. Unfortunately, the ability to bear risk for
individuals or firms is limited by lack of capital. An individual who has lost all his wealth cannot go
back to the roulette table. A firm that is almost bankrupt cannot generally take advantage of the same
opportunities as a firm that is healthy. This forces individuals and firms to avoid risks that are not
profitable so that they can take on more risks that are advantageous. Without derivatives, this is often
impossible. Derivatives enable individuals and firms to shed risks and take on risks cheaply.
To shed risks that are not profitable and take on the ones that are profitable, it is crucial to
understand the risks one is exposed to and to evaluate their costs and benefits. Risks cannot be
analyzed without statistics. One has to be able to quantify risks so that one can understand their costs
and so that one can figure out whether transactions decrease or increase risk and by how much. When
one deals with risks, it is easy to let ones biases take charge of ones decisions. Individuals are just
not very good at thinking about risks without quantitative tools. They will overstate the importance
Chapter 2, page 17
of some risks and understate the importance of others. For instance, individuals put too much weight
on recent past experience. If a stock has done well in the recent past, they will think that it will do
unusually well in the future so that it has little risk. Yet, a quick look at the data will show them that
this is not so. They will also be reluctant to realize losses even though quantitative analysis will show
that it would be in their best interest to do so. Psychologists have found many tendencies that people
have in dealing with risk that lead to behavior that cannot be justified on quantitative grounds. These
tendencies have even led to a new branch of finance called behavioral finance. This branch of finance
attempts to identify how the biases of individuals influence their portfolio decisions and asset returns.
To figure out which risks to bear and which risks to shed, one therefore must have models
that allow us to figure out the economic value of taking risks and shedding risks. Hence, to use
derivatives in the right way, one has to be able to make simple statements like the following: If I keep
my exposure to weather risk, the value of my firm is X; if I shed my exposure to weather risk, the
value of my firm after purchasing the appropriate financial instruments is Y; if Y is greater than X,
I shed the weather risk. For individuals, it has to be that the measure of their welfare they focus on
is affected by a risk and they can establish whether shedding the risk makes them better off than
bearing it. To figure out the economic value of taking risks and shedding risks, one has to be able to
quantify risks. This requires statistics. One has to be able to trace out the impact of risks on firm value
or individual welfare. This requires economic analysis. Finally, one must know how a derivative
position will affect the risks the firm is exposed to. This requires understanding the derivatives and
their pricing. A derivative could eliminate all of a risk, but it may be priced so that one is worse off
without the risk than with. A derivatives salesperson could argue that a derivative is the right one to
eliminate a risk we are concerned about, but a more thorough analysis might reveal that the derivative
Chapter 2, page 18
actually increases our exposure to other risks so that we would be worse off purchasing it.
To use derivatives the right way, one has to define an objective function. For a firm, the
objective function is generally to maximize shareholder wealth. For an investor, there will be some
measure of welfare that she focuses on. Objective functions are of little use unless we can measure
the impact of choices on our objectives. We therefore have to be able to quantify how various risks
affect our objective function. Doing so, we will find some risks that make us worse off and, possibly,
others that make us better off. Having figured out which risks are costly, we need to investigate
whether there are derivatives strategies that can be used to improve our situation. This requires us
to be able to figure out the impact of these strategies on our objective function. The world is not
static. Our exposures to risks change all the time. Consequently, derivatives positions that were
appropriate yesterday may not be today. This means that we have to be able to monitor these
positions and monitor our risk exposures to be able to make changes when it is appropriate to do so.
This means that we must have systems in place that make it possible to monitor our risk exposures.
Using derivatives the right way means that we look ahead and figure out which risks we
should bear and how. Once we have decided which risks we should bear, nature has to run its course.
In our example of the exporter to Europe, after she entered the forward contract, the euro ended up
either above or below the forward price of $0.99. If it ended up above, the exporter actually lost
money on the contract. The temptation would be to say that she made a poor use of derivatives since
she lost money on a derivative. This is simply not the way to think about derivatives use. When the
decision was made to use the derivative, the exporter figured out that she was better off hedging the
currency risk. She had no information that allowed her to figure out that the price of the euro was
going to appreciate and hence could not act on such information. At that time, it was as likely that
Chapter 2, page 19
the exchange rate would fall and that she would have gained from her forward position. If a derivative
is bought to insure against losses, it is reasonable to think that about half the time, the losses one
insures against will not take place and the derivative will therefore not produce a gain to offset losses.
The outcome of a derivatives transactions does not tell us whether we were right or wrong in entering
the transaction any more than whether our house burns down or not tells us whether we were right
or wrong to buy fire insurance. Houses almost never burn down, so that we almost always make a
loss on fire insurance. We buy the insurance because we know ex ante that we are better off shedding
the financial risk of having to replace the house.
Section 1.4. Nineteen steps to using derivatives the right way.
This book has nineteen chapters. Each chapter will help you to understand better how to use
derivatives the right way. Because of the biases in decision making in the absence of quantitative
evaluations, risk has to be evaluated using statistical tools that are not subject to the hidden biases
of the human mind. We therefore have to understand how to measure risk. In chapters 2 through 4,
we investigate how to measure risk and how risk affects firm value and the welfare of individuals. A
crucial issue in risk measurement is that lower tail risks  risks that things can go wrong in a serious
way  affect firm value and individual welfare in ways that are quite different from other risks. Small
cash flow fluctuations around their mean generally have little impact on firm value. Extreme outcomes
can mean default and bankruptcy. It is therefore essential to have quantitative measures of these lower
tail risks. We therefore introduce such measures in chapter 4. These measures enable us to assess the
impact of derivatives strategies on risk and firm value. As we consider different types of derivatives
throughout the book, we will have to make sure that we are able to use our risk measures to evaluate
Chapter 2, page 20
these derivatives.
After chapter 4, we will have the main framework of risk management and derivatives use in
place. We will know how to quantify risks, how to evaluate their costs and benefits, and how to make
decisions when risk matters. This framework is then used throughout the rest of the book to guide
us in figuring out how to use derivatives to manage risk. As we progress, however, we learn about
derivatives uses but also learn more about how to quantify risk. We start by considering the uses and
pricing of plain vanilla derivatives. In chapter 5, we therefore discuss the pricing of forward contracts
and of futures contracts. Futures contracts are similar to forward contracts but are traded on
organized exchanges. Chapters 6 through 9 discuss extensively how to use forward and futures
contracts to manage risk. We show how to set up hedges with forwards and futures. Chapter 8
addresses many of the issues that arise in estimating foreign exchange rate exposures and hedging
them. Chapter 9 focuses on interest rate risks.
After having seen how to use forwards and futures, we turn our attention on options. Chapter
10 shows why options play an essential role in risk management. We analyze the pricing of options
in chapters 11 and 12. Chapter 12 is completely devoted to the BlackScholes formula. Unfortunately,
options complicate risk measurement. The world is full of options, so that one cannot pretend that
they do not exist to avoid the risk measurement problem. Chapter 13 therefore extends our risk
measurement apparatus to handle options and more complex derivatives. Chapter 14 covers fixed
income options. After chapter 14, we will have studied plain vanilla derivatives extensively and will
know how to use them in risk management. We then move beyond plain vanilla derivatives. In chapter
15, we address the tradeoffs that arise when using derivatives that are not plain vanilla derivatives.
We then turn to swaps in chapter 16. Swaps are exchanges of cash flows: one party pays welldefined
Chapter 2, page 21
cash flows to the other party in exchange for receiving welldefined cash flows from that party. The
simplest swap is one where one party promises to pay cash flows corresponding to the interest
payments of fixed rate debt on a given amount to a party that promises to pay cash flows
corresponding to the payments of floating rate debt on the same amount. We will see that there are
lots of different types of swaps. In chapter 17, we discuss the pricing and uses of exotic options.
Credit risks are important by themselves because they are a critical source of risk for firms. At the
same time, one of the most recent growth areas in derivative markets involves credit derivatives,
namely derivatives that can be used to lay off credit risks. In chapter 18, we analyze credit risks and
show how they can be eliminated through the uses of credit derivatives.
After developing the BlackScholes formula, eventually Fischer Black, Robert Merton, and
Myron Scholes all played major roles in the business world. Fischer Black became a partner at
Goldman Sachs, dying prematurely in 1996. Robert Merton and Myron Scholes became partners in
a highflying hedge fund company named Longterm Capital Management that made extensive use
of derivatives. In 1997, Robert Merton and Myron Scholes received the Nobel Memorial Prize in
Economics for their contribution to the pricing of options. In their addresses accepting the prize, both
scholars focused on how derivatives can enable individuals and firms to manage risks. In September
1998, the Federal Reserve Bank of New York arranged for a group of major banks to lend billions
of dollars to that hedge fund. The Fed intervened because the fund had lost more than four billion
dollars of its capital, so it now had less than half a billion dollars to support a balance sheet of more
than $100 billion. Additional losses would have forced the longterm capital fund to unwind positions
in a hurry, leading regulators to worry that this would endanger the financial system of the Western
world. The press was full of articles about how the best and the brightest had failed. This led to much
Chapter 2, page 22
chestbeating about our ability to manage risk. Some thought that if Nobel prizewinners could not
get it right, there was little hope for the rest of us. James Galbraith in an article in the Texas Observer
even went so far as to characterize their legacy as follows: They will be remembered for having tried
and destroyed, completely, utterly and beyond any redemption, their own theories.
In the last chapter, we will consider the lessons of this book in the light of the LTCM
experience. Not surprisingly, we will discover that the experience of LTCM does not change the main
lessons of this book and that, despite the statements of James Galbraith, the legacy of Merton and
Scholes will not be the dramatic losses of LTCM but their contribution to our understanding of
derivatives. This book shows that risks can be successfully managed with derivatives. For those who
hear about physicists and mathematicians flocking to Wall Street to make fortunes in derivatives, you
will be surprised to discover that this book is not about rocket science. If there was a lesson from
LTCM, it is that derivatives are too important to be left to rocket scientists. What makes financial
markets different from the experiments that physicists focus on in their labs, it is that financial history
does not repeat itself. Markets are new every day. They surprise us all the time. There is no
mathematical formula that guarantees success every time.
After studying this book, all you will know is how, through careful use of derivatives, you can
increase shareholder wealth and improve the welfare of individuals. Derivatives are like finely tuned
racing cars. One would not think of letting an untutored driver join the Indianapolis 500 at the wheel
of a race car. However, if the untutored driver joins the race at the wheel of a Ford Escort, he has
no chance of ever winning. The same is true with derivatives. Untutored users can crash and burn.
Nonusers are unlikely to win the race.
Chapter 2, page 23
Literature Note
Bernstein (1992) provides a historical account of the interaction between research and practice in the
history of derivatives markets. The spectacular growth in financial innovation is discussed in Miller
(1992). Finnerty (1992) provides a list of new financial instruments developed since the discovery of
the BlackScholes formula. Black () provides an account of the discovery of the BlackScholes
formula. Allen and Gale (), Merton (1992), and Ross (1989) provide an analysis of the determinants
of financial innovation and Merton (1992).
Chapter 2, page 24
5 10 15 20 25 30
0.2
0.4
0.6
0.8
Figure 1.1. Payoff of derivative which pays the 10m times the excess of the square of the
decimal interest rate over 0.01.
Million dollars
Interest rate in percent
Chapter 2, page 25
Exchange rate
Income to firm
999,000
Unhedged income
0.99 0.90
900,000
Exchange rate
Income to firm
Forward
gain
Forward
loss
0.99
0.9
99,000
Exchange rate
Income to firm
Forward
gain
Forward
loss 999,000
Unhedged income
Hedged income
0.99
Figure 1.2. Hedging with forward contract. The firms income is in dollars and the exchange rate
is the dollar price of one euro.
Panel A. Income to unhedged exporter. The exporter receives euro 1m in 90 days, so that the
dollar income is the dollar price of the euro times 1m if the exporter does not hedge.
Panel B. Forward contract payoff. The
forward price for the euro is $0.99. If the spot
exchange rate is $0.9, the gain from the
forward contract is the gain from selling euro
1m at $0.99 rather than $0.9.
Panel C. Hedged firm income. The firm sells
its euro income forward at a price of $0.99 per
euro. It therefore gets a dollar income of
$990,000 for sure, which is equal to the
unhedged firm income plus the forward
contract payoff.
Chapter 2, page 26
Amazon.com price
105
Payoff
20 75
55
+30
Amazon.com price
105
Payoff
75
0
20
10
20
Figure 1.3. Payoff of share and call option strategies.
Figure 1.3.A. Payoff of buying one share of Amazon.com at $75.
Figure 1.3.B. Payoff of buying a call option on one share of Amazon.com with exercise price
of $75 for a premium of $10.
Chapter 2, page 27
Chapter 2: Investors, Derivatives, and Risk Management
Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Section 2.1. Evaluating the risk and the return of individual securities and portfolios. . . . 3
Section 2.1.1. The risk of investing in IBM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Section 2.1.2. Evaluating the expected return and the risk of a portfolio. . . . . . 11
Section 2.2. The benefits from diversification and their implications for expected returns.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Section 2.2.1. The riskfree asset and the capital asset pricing model . . . . . . . . . 21
Section 2.2.2. The risk premium for a security. . . . . . . . . . . . . . . . . . . . . . . . . . 24
Section 2.3. Diversification and risk management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Section 2.3.1. Risk management and shareholder wealth. . . . . . . . . . . . . . . . . . 36
Section 2.3.2. Risk management and shareholder clienteles . . . . . . . . . . . . . . . . 41
Section 2.3.3. The risk management irrelevance proposition. . . . . . . . . . . . . . . 46
1) Diversifiable risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
2) Systematic risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
3) Risks valued by investors differently than predicted by the CAPM . . . 46
Hedging irrelevance proposition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Section 2.4. Risk management by investors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Section 2.5. Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Literature Note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Questions and exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Figure 2.1. Cumulative probability function for IBM and for a stock with same return and
twice the volatility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Figure 2.2. Normal density function for IBM assuming an expected return of 13% and a
volatility of 30% and of a stock with the same expected return but twice the
volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Figure 2.3. Efficient frontier without a riskless asset . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Figure 2.4. The benefits from diversification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Figure 2.5. Efficient frontier without a riskless asset. . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Figure 2.6. Efficient frontier with a riskfree asset. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Figure 2.7. The CAPM. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 66
Box: Tbills. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 67
Box: The CAPM in practice. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68
SUMMARY OUTPUT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Chapter 2: Investors, Derivatives, and Risk Management
December 1, 1999
Ren M. Stulz 1997, 1999
1
Chapter objectives
1. Review expected return and volatility for a security and a portfolio.
2. Use the normal distribution to make statements about the distribution of returns of a portfolio.
3. Evaluate the risk of a security in a portfolio.
4. Show how the capital asset pricing model is used to obtain the expected return of a security.
4. Demonstrate how hedging affects firm value in perfect financial markets.
5. Show how investors evaluate risk management policies of firms in perfect financial markets.
6. Show how investors can use risk management and derivatives in perfect financial markets to make
themselves better off.
2
During the 1980s and part of the 1990s, two gold mining companies differed dramatically in
their risk management policies. One company, Homestake, had a policy of not managing its gold price
risk at all. Another company, American Barrick, had a policy of eliminating most of its gold price risk
using derivatives. In this chapter we investigate whether investors prefer one policy to the other and
why. More broadly, we consider how investors evaluate the risk management policies of the firms
in which they invest. In particular, we answer the following question: When does an investor want
a firm in which she holds shares to spend money to reduce the volatility of its stock price?
To find out how investors evaluate firm risk management policies, we have to study how
investors decide to invest their money and how they evaluate the riskiness of their investments. We
therefore examine first the problem of an investor that can invest in two stocks, one of them IBM and
the other a fictional one that we call XYZ. This examination allows us to review concepts of risk and
return and to see how one can use a probability distribution to estimate the risk of losing specific
amounts of capital invested in risky securities. Throughout this book, it will be of crucial importance
for us to be able to answer questions such as: How likely is it that the value of a portfolio of securities
will fall by more than 10% over the next year? In this chapter, we show how to answer this question
when the portfolio does not include derivatives.
Investors have two powerful risk management tools at their disposal that enable them to
invest their wealth with a level of risk that is optimal for them. The first tool is asset allocation. An
investors asset allocation specifies how her wealth is allocated across types of securities or asset
classes. For instance, for an investor who invests in equities and the riskfree asset, the asset
allocation decision involves choosing the fraction of his wealth invested in equities. By investing less
in equities and more in the riskfree asset, the investor reduces the risk of her invested wealth. The
3
second tool is diversification. Once the investor has decided how much to invest in an asset class,
she has to decide which securities to hold and in which proportion. A portfolios diversification is the
extent to which the funds invested are distributed across securities to reduce the dependence of the
portfolios return on the return of individual securities. If a portfolio has only one security, it is not
diversified and the investor always loses if that security performs poorly. A diversified portfolio can
have a positive return even though some of its securities make losses because the gains from the other
securities can offset these losses. Diversification therefore reduces the risk of funds invested in an
asset class. We will show that these risk management tools imply that investors do not need the help
of individual firms to achieve their optimal riskreturn takeoff. Because of the availability of these risk
management tools, investors only benefit from a firms risk management policy if that policy
increases the present value of the cash flows the firm is expected to generate. In the next chapter, we
demonstrate when and how risk management by firms can make investors better off.
After having seen the conditions that must be met for a firms risk management policy to
increase firm value, we turn to the question of when investors have to use derivatives as additional
risk management tools. We will see that derivatives enable investors to purchase insurance, to hedge,
and to take advantage of their views more efficiently.
Section 2.1. Evaluating the risk and the return of individual securities and portfolios.
Consider the situation of an investor with wealth of $100,000 that she wants to invest for one
year. Her broker recommends two common stocks, IBM and XYZ. The investor knows about IBM,
but has never heard of XYZ. She therefore decides that first she wants to understand what her wealth
will amount to after holding IBM shares for one year. Her wealth at the end of the year will be her
4
initial wealth times one plus the rate of return of the stock over that period. The rate of return of the
stock is given by the price appreciation plus the dividend payments divided by the stock price at the
beginning of the year. So, if the stock price is $100 at the beginning of the year, the dividend is $5,
and the stock price appreciates by $20 during the year, the rate of return is (20 + 5)/100 or 25%.
Throughout the analysis in this chapter, we assume that the frictions which affect financial
markets are unimportant. More specifically, we assume that there are no taxes, no transaction costs,
no costs to writing and enforcing contracts, no restrictions on investments in securities, no differences
in information across investors, and investors take prices as given because they are too small to affect
prices. Financial economists call markets that satisfy the assumptions we just listed perfect financial
markets. The assumption of the absence of frictions stretches belief, but it allows us to zero in on
firstorder effects and to make the point that in the presence of perfect financial markets risk
management cannot increase the value of a firm. In chapter 3, we relax the assumption of perfect
financial markets and show how departures from this assumption make it possible for risk
management to create value for firms. For instance, taxes make it advantageous for firms and
individuals to have more income when their tax rate is low and less when their tax rate is high. Risk
management with derivatives can help firms and individuals achieve this objective.
Section 2.1.1. The risk of investing in IBM.
Since stock returns are uncertain, the investor has to figure out which outcomes are likely and
which are not. To do this, she has to be able to measure the likelihood of possible returns. The
statistical tool used to measure the likelihood of various returns for a stock is called the stocks
return probability distribution. A probability distribution provides a quantitative measure of the
5
likelihood of the possible outcomes or realizations for a random variable. Consider an urn full of balls
with numbers on them. There are multiple balls with the same number on them. We can think of a
random variable as the outcome of drawing a ball from the urn. The urn has lots of different balls, so
that we do not know which number will come up. The probability distribution specifies how likely
it is that we will draw a ball with a given number by assigning a probability for each number that can
take values between zero and one. If many balls have the same number, it is more likely that we will
draw a ball with that number so that the probability of drawing this number is higher than the
probability of drawing a number which is on fewer balls. Since a ball has to be drawn, the sum of the
probabilities for the various balls or distinct outcomes has to sum to one. If we could draw from the
urn a large number of times putting the balls back in the urn after having drawn them, the average
number drawn would be the expected value. More precisely, the expected value is a probability
weighted average of the possible distinct outcomes of the random variable. For returns, the
expected value of the return is the return that the investor expects to receive. For instance, if a stock
can have only one of two returns, 10% with probability 0.4 and 15% with probability 0.6, its expected
return is 0.4*10% + 0.6*15% or 13%.
The expected value of the return of IBM, in short IBMs expected return, gives us the
average return our investor would earn if next year was repeated over and over, each time yielding
a different return drawn from the distribution of the return of IBM. Everything else equal, the investor
is better off the greater the expected return of IBM. We will see later in this chapter that a reasonable
estimate of the expected return of IBM is about 13% per year. However, over the next year, the
return on IBM could be very different from 13% because the return is random. For instance, we will
find out that using a probability distribution for the return of IBM allows us to say that there is a 5%
6
chance of a return greater than 50% over a year for IBM. The most common probability distribution
used for stock returns is the normal distribution. There is substantial empirical evidence that this
distribution provides a good approximation of the true, unknown, distribution of stock returns.
Though we use the normal distribution in this chapter, it will be important later on for us to explore
how good this approximation is and whether the limitations of this approximation matter for risk
management.
The investor will also want to know something about the risk of the stock. The variance
of a random variable is a quantitative measure of how the numbers drawn from the urn are spread
around their expected value and hence provides a measure of risk. More precisely, it is a probability
weighted average of the square of the differences between the distinct outcomes of a random variable
and its expected value. Using our example of a return of 10% with probability 0.6 and a return of
15% with probability 0.4, the decimal variance of the return is 0.4*(0.10  0.13)
2
+ 0.6*(0.15  0.13)
2
or 0.0006. For returns, the variance is in units of the square of return differences from their expected
value. The square root of the variance is expressed in the same units as the returns. As a result, the
square root of the return variance is in the same units as the returns. The square root of the variance
is called the standard deviation. In finance, the standard deviation of returns is generally called the
volatility of returns. For our example, the square root of 0.0006 is 0.0245. Since the volatility is in
the same units as the returns, we can use a volatility in percent or 2.45%. As returns are spread
farther from the expected return, volatility increases. For instance, if instead of having returns of 10%
and 15% in our example, we have returns of 2.5% and 20%, the expected return is unaffected but the
volatility becomes 8.57% instead of 2.45%.
If IBMs return volatility is low, the absolute value of the difference between IBMs return
7
and its expected value is likely to be small so that a return substantially larger or smaller than the
expected return would be surprising. In contrast, if IBMs return volatility is high, a large positive or
negative return would not be as surprising. As volatility increases, therefore, the investor becomes
less likely to get a return close to the expected return. In particular, she becomes more likely to have
low wealth at the end of the year, which she would view adversely, or really high wealth, which she
would like. Investors are generally riskaverse, meaning that the adverse effect of an increase in
volatility is more important for them than the positive effect, so that on net they are worse off when
volatility increases for a given expected return.
The cumulative distribution function of a random variable x specifies, for any number X,
the probability that the realization of the random variable will be no greater than X. We denote the
probability that the random variable x has a realization no greater than X as prob(x # X). For our urn
example, the cumulative distribution function specifies the probability that we will draw a ball with
a number no greater than X. If the urn has balls with numbers from one to ten, the probability
distribution function could specify that the probability of drawing a ball with a number no greater than
6 is 0.4. When a random variable is normally distributed, its cumulative distribution function depends
only on its expected value and on its volatility. A reasonable estimate of the volatility of the IBM
stock return is 30%. With an expected return of 13% and a volatility of 30%, we can draw the
cumulative distribution function for the return of IBM. The cumulative distribution function for IBM
is plotted in Figure 2.1. It is plotted with returns on the horizontal axis and probabilities on the
vertical axis. For a given return, the function specifies the probability that the return of IBM will not
exceed that return. To use the cumulative distribution function, we choose a value on the horizontal
axis, say 0%. The corresponding value on the vertical axis tells us the probability that IBM will earn
8
less than 0%. This probability is 0.32. In other words, there is a 32% chance that over one year, IBM
will have a negative return. Such probability numbers are easy to compute for the normal distribution
using the NORMDIST function of Excel. Suppose we want to know how likely it is that IBM will
earn less than 10% over one year. To get the probability that the return will be less than 10%, we
choose x = 0.10. The mean is 0.13 and the standard deviation is 0.30. We finally write TRUE in the
last line to obtain the cumulative distribution function. The result is 0.46. This number means that
there is a 46% chance that the return of IBM will be less than 10% over a year.
Our investor is likely to be worried about making losses. Using the normal distribution, we
can tell her the probability of losing more than some specific amount. If our investor would like to
know how likely it is that she will have less than $100,000 at the end of the year if she invests in IBM,
we can compute the probability of a loss using the NORMDIST function by noticing that a loss means
a return of less than 0%. We therefore use x = 0 in our above example instead of x = 0.1. We find that
there is a 33% chance that the investor will lose money. This probability depends on the expected
return. As the expected return of IBM increases, the probability of making a loss falls.
Another concern our investor might have is how likely it is that her wealth will be low enough
that she will not be able to pay for living expenses. For instance, the investor might decide that she
needs to have $50,000 to live on at the end of the year. She understands that by putting all her wealth
in a stock, she takes the risk that she will have less than that amount at the end of the year and will
be bankrupt. However, she wants that risk to be less than 5%. Using the NORMDIST function, the
probability of a 50% loss for IBM is 0.018. Our investor can therefore invest in IBM given her
objective of making sure that there is a 95% chance that she will have $50,000 at the end
of the year.
9
The probability density function of a random variable tells us the change in prob(x # X)
as X goes to its next possible value. If the random variable takes discrete values, the probability
density function tells us the probability of x taking the next higher value. In our example of the urn,
the probability density function tells us the probability of drawing a given number from the urn. We
used the example where the urn has balls with numbers from one through ten and the probability of
drawing a ball with a number no greater than six is 0.4. Suppose that the probability of drawing a ball
with a number no greater than seven is 0.6. In this case, 0.6  0.4 is the probability density function
evaluated at seven and it tells us that the probability of drawing the number seven is 0.2. If the
random variable is continuous, the next higher value than X is infinitesimally close to X.
Consequently, the probability density function tells us the increase in prob(x # X) as X increases by
an infinitesimal amount, say ,. This corresponds to the probability of x being between X and X + ,.
If we wanted to obtain the probability of x being in an interval between X and X + 2,, we would add
the probability of x being in an interval between X and X + , and then the probability of x being in
an interval between X + , to X + 2,. More generally, we can also obtain the probability that x will
be in an interval from X to X by adding upthe probability density function from X to X, so that
the probability that x will take a value in an interval corresponds to the area under the probability
density function from X to X.
In the case of IBM, we see that the cumulative distribution function first increases slowly, then
more sharply, and finally again slowly. This explains that the probability density function of IBM
shown in Figure 2.2. first has a value close to zero, increases to reach a peak, and then falls again.
This bellshaped probability density function is characteristic of the normal distribution. Note that this
bellshaped function is symmetric around the expected value of the distribution. This means that the
10
cumulative distribution function increases to the same extent when evaluated at two returns that have
the same distance from the mean on the horizontal axis. For comparison, the figure shows the
distribution of the return of a security that has twice the volatility of IBM but the same expected
return. The distribution of the more volatile security has more weight in the tails and less around the
mean than IBM, implying that outcomes substantially away from the mean are more likely. The
distribution of the more volatile security shows a limitation of the normal distribution: It does not
exclude returns worse than 100%. In general, this is not a serious problem, but we will discuss this
problem in more detail in chapter 7.
When interpreting probabilities such as the 0.18 probability of losing 50% of an investment
in IBM, it is common to state that if our investor invests in IBM for 100 years, she can expect to lose
more than 50% of her beginning of year investment slightly less than two years out of 100. Such a
statement requires that returns of IBM are independent across years. Two random variables a and
b are independent if knowing the realization of random variable a tells us nothing about the realization
of random variable b. The returns to IBM in years i and j are independent if knowing the return of
IBM in year i tells us nothing about the return of IBM in year j. Another way to put this is that,
irrespective of what IBM earned in the previous year (e.g., +100% or  50%), our best estimate of
the mean return for IBM is 13%.
There are two good reasons for why it makes sense to consider stock returns to be
independent across years. First, this seems to be generally the case statistically. Second, if this was
not roughly the case, there would be money on the table for investors. To see this, suppose that if
IBM earns 100% in one year it is likely to have a negative return the following year. Investors who
know that would sell IBM since they would not want to hold a stock whose value is expected to fall.
11
By their actions, investors would bring pressure on IBMs share price. Eventually, the stock price will
be low enough that it is not expected to fall and that investing in IBM is a reasonable investment. The
lesson from this is that whenever security prices do not incorporate past information about the history
of the stock price, investors take actions that make the security price incorporate that information.
The result is that markets are generally weakform efficient. The market for a security is weakform
efficient if all past information about the past history of that security is incorporated in its price. With
a weakform efficient market, technical analysis which attempts to forecast returns based on
information about past returns is useless. In general, public information gets incorporated in security
prices quickly. A market where public information is immediately incorporated in prices is called a
semistrong form efficient market. In such a market, no money can be made by trading on
information published in the Wall Street Journal because that information is already incorporated
in security prices. A strong form efficient market is one where all economically relevant information
is incorporated in prices, public or not. In the following, we will call a market to be efficient when
it is semistrong form efficient, so that all public information is incorporated in prices.
Section 2.1.2. Evaluating the expected return and the risk of a portfolio.
To be thorough, the investor wants to consider XYZ. She first wants to know if she would
be better off investing $100,000 in XYZ rather than in IBM. She finds out that the expected return
of XYZ is 26% and the standard deviation of the return is 60%. In other words, XYZ has twice the
expected return and twice the standard deviation of IBM. This means that, using volatility as a
summary risk measure, XYZ is riskier than IBM. Figure 2.2. shows the probability density function
of a return distribution that has twice the volatility of IBM. Since XYZ has twice the expected return,
12
its probability density function would be that distribution moved to the right so that its mean is 26%.
It turns out that the probability that the price of XYZ will fall by 50% is 10.2%. Consequently, our
investor cannot invest all her wealth in XYZ because the probability of losing $50,000 would exceed
5%.
We now consider the volatility and expected return of a portfolio that includes both IBM and
XYZ shares. At the end of the year, the investors portfolio will be $100,000 times one plus the
return of her portfolio. The return of a portfolio is the sum of the return on each security in the
portfolio times the fraction of the portfolio invested in the security. The fraction of the portfolio
invested in a security is generally called the portfolio share of that security. Using w
i
for the portfolio
share of the ith security in a portfolio with N securities and R
i
for the return on the ith security, we
have the following formula for the portfolio return:
(2.1.) w R Portfolio Return
i i
i 1
N
=
=
Suppose the investor puts $75,000 in IBM and $25,000 in XYZ. The portfolio share of IBM is
$75,000/$100,000 or 0.75. If, for illustration, the return of IBM is 20% and the return on XYZ is 
10%, applying formula (2.1.) gives us a portfolio return in decimal form of:
0.75*0.20 + 0.25*(0.10) = 0.125
In this case, the wealth of the investor at the end of the year is 100,000(1+0.125) or $125,000.
At the start of the year, the investor has to make a decision based on what she expects the
13
distribution of returns to be. She therefore wants to compute the expected return of the portfolio and
the return volatility of the portfolio. Denote by E(x) the expected return of random variable x, for any
x. To compute the portfolios expected return, it is useful to use two properties of expectations. First,
the expected value of a random variable multiplied by a constant is the constant times the expected
value of the random variable. Suppose a can take value a
1
with probability p and a
2
with probability
1p.
If k is a constant, we have that E(k*a) = pka
1
+ (1p)k a
2
= k[pa
1
+ (1p)a
2
] = kE(a).
Consequently, the expected value of the return of a security times its portfolio share, E(w
i
R
i
) is equal
to w
i
E(R
i
). Second, the expected value of a sum of random variables is the sum of the expected values
of the random variables. Consider the case of random variables which have only two outcomes, so
that a
1
and b
1
have respectively outcomes a and b with probability p and a
2
and b
2
with probability
(1p). With this notation, we have E(a + b) = p(a
1
+ b
1
) + (1p)(a
2
+ b
2
) = pa
1
+ (1p)a
2
+ pb
1
+(1
p)b
2
= E(a) + E(b). This second property implies that if the portfolio has only securities 1 and 2, so
that we want to compute E(w
1
R
1
+ w
2
R
2
), this is equal to E(w
1
R
1
) + E(w
2
R
2
), which is equal to
w
1
E(R
1
) + w
2
E(R
2
) because of the first property. With these properties of expectations, the expected
return of a portfolio is therefore the portfolio share weighted average of the securities in the portfolio:
(2.2.) w E(R ) Portfolio Expected Return
i i
i 1
N
=
=
Applying this formula to our problem, we find that the expected return of the investors portfolio in
decimal form is:
0.75*0.13 + 0.25*0.26 = 0.1625
Our investor therefore expects her wealth to be 100,000*(1 + 0.1625) or $116,250 at the end of the
14
year.
Our investor naturally wants to be able to compare the risk of her portfolio to the risk of
investing all her wealth in IBM or XYZ. To do that, she has to compute the volatility of the portfolio
return. The volatility is the square root of the variance. The variance of a portfolios return is the
expected value of the square of the difference between the portfolios return and its expected return,
E[R
p
 E(R
p
)]
2
. To get the volatility of the portfolio return, it is best to first compute the variance and
then take the square root of the variance. To compute the variance of the portfolio return, we first
need to review two properties of the variance. Denote by Var(x) the variance of random variable x,
for any x. The first property is that the variance of a constant times random variable a is the constant
squared times the variance of a. For instance, the variance of 10 times a is 100 times the variance of
a. This follows from the definition of the variance of a as E[a  E(a)]
2
. If we compute the variance
of ka, we have E[ka  E(ka)]
2
. Since k is not a random variable, we can remove it from the
expectation to get the variance of ka as k
2
E[a  E(a)]
2
. This implies that Var(w
i
R
i
) = w
i
2
Var(R
i
).
To obtain the variance of a + b, we have to compute E[a+b  E(a + b)]
2
. Remember that the square
of a sum of two terms is the sum of each term squared plus two times the crossproduct of the two
numbers (the square of 5 + 4 is 5
2
+ 4
2
+ 2*5*4, or 81). Consequently:
Var(a + b) = E[a + b  E(a + b)]
2
= E[a  E(a) + b  E(b)]
2
= E[a  E(a)]
2
+ E[b  E(b)]
2
+
2E[a  E(a)][b  E(b)]
= Var(a) + Var(b) + 2Cov(a,b)
15
The bold term is the covariance between a and b, denoted by Cov(a,b). The covariance is a measure
of how a and b move together. It can take negative as well as positive values. Its value increases as
a and b are more likely to exceed their expected values simultaneously. If the covariance is zero, the
fact that a exceeds its expected value provides no information about whether b exceeds its expected
value also. The covariance is closely related to the correlation coefficient. The correlation coefficient
takes values between minus one and plus one. If a and b have a correlation coefficient of one, they
move in lockstep in the same direction. If the correlation coefficient is 1, they move in lockstep in
the opposite direction. Finally, if the correlation coefficient is zero, a and b are independent. Denote
by Vol(x) the volatility of x, for any x, and by Corr(x,y) the correlation between x and y, for any x
and y. If one knows the correlation coefficient, one can obtain the covariance by using the following
formula:
Cov(a,b) = Corr(a,b)*Vol(a)*Vol(b)
The variance of a and b increases with the covariance of a and b since an increase in the covariance
makes it less likely that an unexpected low value of a is offset by an unexpected high value of b. It
therefore follows that the Var(a + b) increases with the correlation between a and b. In the special
case where a and b have the same volatility, a + b has no risk if the correlation coefficient between
a and b is minus one because a high value of one of the variables is always exactly offset by a low
value of the other, insuring that the sum of the realizations of the random variables is always equal
to the sum of their expected values. To see this, suppose that both random variables have a volatility
of 0.2 and a correlation coefficient of minus one. Applying our formula for the covariance, we have
16
w Var(R ) w w Cov(R , R ) Variance of Portfolio Return
i
2
i i j i j
j i
N
i 1
N N
+ =
= =
i 1
that the covariance between a and b is equal to 1*0.2*0.2, which is 0.04. The variance of each
random variable is the square of 0.2, or 0.04. Applying our formula, we have that Var(a + b) is equal
to 0.04 + 0.04  2*0.04 = 0. Note that if a and b are the same random variables, they have a
correlation coefficient of plus one, so that Cov(a,b) is Cov(a,a) = 1*Vol(a)Vol(a), which is Var(a).
Hence, the covariance of a random variable with itself is its variance.
Consider the variance of the return of a portfolio with securities 1 and 2, Var(w
1
R
1
+ w
2
R
2
).
Using the formula for the variance of a sum, we have that Var(w
1
R
1
+ w
2
R
2
) is equal to Var(w
1
R
1
)
+ Var(w
2
R
2
) +2Cov(w
1
R
1
,w
2
R
2
). Using the result that the variance of ka is k
2
Var(a), we have that
w
1
2
Var(R
1
) + w
2
2
Var(R
2
) +2w
1
w
2
Cov(R
1
,R
2
). More generally, therefore, the formula for the variance
of the return of a portfolio is:
(2.3.)
Applying the formula to our portfolio of IBM and XYZ, we need to know the covariance between
the return of the two securities. Lets assume that the correlation coefficient between the two
securities is 0.5. In this case, the covariance is 0.5*0.30*0.60 or 0.09. This gives us the following
variance:
0.75
2
*0.3
2
+ 0.25
2
*0.6
2
+2*0.25*0.75*0.5*0.3*0.6 = 0.11
The volatility of the portfolio is the square root of 0.11, which is 0.33. Our investor therefore
discovers that by investing less in IBM and investing some of her wealth in a stock that has twice the
volatility of IBM, she can increase her expected return from 13% to 16.25%, but in doing so she
17
increases the volatility of her portfolio from 30% to 32.70%. We cannot determine a priori which
of the three possible investments (investing in IBM, XYZ, or the portfolio) the investor prefers. This
is because the portfolio has a higher expected return than IBM but has higher volatility. We know that
the investor would prefer the portfolio if it had a higher expected return than IBM and less volatility,
but this is not the case. An investor who is riskaverse is willing to give up some expected return in
exchange for less risk. If the investor dislikes risk sufficiently, she prefers IBM to the portfolio
because IBM has less risk even though it has less expected return. By altering portfolio shares, the
investor can create many possible portfolios. In the next section, we study how the investor can
choose among these portfolios.
Section 2.2. The benefits from diversification and their implications for expected returns.
We now consider the case where the return correlation coefficient between IBM and XYZ
is zero. In this case, the decimal variance of the portfolio is 0.07 and the volatility is 26%. As can be
seen from the formula for the expected return of a portfolio (equation (2.1.)), the expected return of
a portfolio does not depend on the covariance of the securities that compose the portfolio.
Consequently, as the correlation coefficient between IBM and XYZ changes, the expected return of
the portfolio is unchanged. However, as a result of selling some of the low volatility stock and buying
some of the high volatility stock, the volatility of the portfolio falls from 30% to 26% for a constant
expected return. This means that when IBM and XYZ are independent, an investor who has all her
wealth invested in IBM can become unambiguously better off by selling some IBM shares and buying
shares in a company whose stock return has twice the volatility of IBM.
That our investor wants to invest in XYZ despite its high volatility is made clear in figure 2.3.
18
In that figure, we draw all the combinations of expected return and volatility that can be obtained by
investing in IBM and XYZ. We do not restrict portfolio shares to be positive. This means that we
allow investors to sell shares of one company short as long as all their wealth is fully invested so that
the portfolio shares sum to one. With a shortsale, an investor borrows shares from a third party and
sells them. When the investor wants to close the position, she must buy shares and deliver them to
the lender. If the share price increases, the investor loses because she has to pay more for the shares
she delivers than she received for the shares she sold. In contrast, a shortsale position benefits from
decreases in the share price. With a shortsale, the investor has a negative portfolio share in a security
because she has to spend an amount of money at maturity to unwind the shortsale of one share equal
to the price of the share at the beginning of the period plus its return. Consequently, if a share is sold
short, its return has to be paid rather than received. The upwardsloping part of the curve drawn in
figure 2.3. is called the efficient frontier. Our investor wants to choose portfolios on the efficient
frontier because, for each volatility, there is a portfolio on the efficient frontier that has a higher
expected return than any other portfolio with the same volatility. In the case of the volatility of IBM,
there is a portfolio on the frontier that has the same volatility but a higher expected return, so that
IBM is not on the efficient frontier. That portfolio, portfolio y in the figure, has an expected return
of 18.2%. The investor would always prefer that portfolio to holding only shares of IBM.
The investor prefers the portfolio to holding only shares of IBM because she benefits from
diversification. The benefit of spreading a portfolios holdings across different securities is the
volatility reduction that naturally occurs when one invests in securities whose returns are not perfectly
correlated: the poor outcomes of some securities are offset by the good outcomes of other securities.
In our example, XYZ could do well when IBM does poorly. This cannot happen when both securities
19
( )
Volatility of portfolio (1/ N) *0.3
N*(1/ N) *0.3 ((1/ N) *0.3 )
2 2
i 1
N
0.5
2 2
0.5
2 0.5
=
= =
=
are perfectly correlated because then they always do well or poorly together. As the securities become
less correlated, it becomes more likely that one security does well and the other poorly at the same
time. In the extreme case where the correlation coefficient is minus one, IBM always does well when
XYZ does poorly, so that one can create a portfolio of IBM and XYZ that has no risk. To create such
a portfolio, choose the portfolio shares of XYZ and IBM that sum to one and that set the variance
of the portfolio equal to zero. The portfolio share of XYZ is 0.285 and the portfolio share of IBM
is 0.715. This offsetting effect due to diversification means that the outcomes of a portfolio are less
dispersed than the outcomes of many and sometimes all of the individual securities that comprise the
portfolio.
To show that it is possible for diversification to make the volatility of a portfolio smaller than
the volatility of any security in the portfolio, it is useful to consider the following example. Suppose
that an investor can choose to invest among many uncorrelated securities that all have the same
volatility and the same expected return as IBM. In this case, putting the entire portfolio in one
security yields a volatility of 30% and an expected return of 13%. Dividing ones wealth among N
such uncorrelated securities has no impact on the expected return because all securities have the same
expected return. However, using our formula, we find that the volatility of the portfolio is:
Applying this result, we find that for N = 10, the volatility is 9%, for N = 100 it is 3%, and for N =
1000 it is less than 1%. As N is increased further, the volatility becomes infinitesimal. In other words,
20
by holding uncorrelated securities, one can eliminate portfolio volatility if one holds sufficiently many
of these securities! Risk that disappears in a welldiversified portfolio is called diversifiable risk. In
our example, all of the risk of each security becomes diversifiable as N increases.
In the real world, though, securities tend to be positively correlated because changes in
aggregate economic activity affect most firms. For instance, news of the onset of a recession is
generally bad news for almost all firms. As a result, one cannot eliminate risk through diversification
but one can reduce it. Figure 2.4. shows how investors can substantially reduce risk by diversifying
using common stocks available throughout the world. The figure shows how, on average, the
variance of an equallyweighted portfolio of randomly chosen securities is related to the number of
securities in the portfolio. As in our simple example, the variance of a portfolio falls as the number
of securities is increased. This is because, as the number of securities increases, it becomes more likely
that some bad event that affects one security is offset by some good event that affects another
security. Interestingly, however, most of the benefit from diversification takes place when one goes
from one security to ten. Going from 50 securities in a portfolio to 100 does not bring much in terms
of variance reduction. Another important point from the figure is that the variance falls more if one
selects securities randomly in the global universe of securities rather than just within the U.S. The
lower variance of the portfolios consisting of both U.S. and foreign securities reflects the benefits
from international diversification.
Irrespective of the universe from which one chooses securities to invest in, there is always an
efficient frontier that has the same form as the one drawn in figure 2.3. With two securities, they are
both on the frontier. With more securities, this is no longer the case. In fact, with many securities,
individual securities are generally inside the frontier so that holding a portfolio dominates holding a
21
single security because of the benefits of diversification. Figure 2.5. shows the efficient frontier
estimated at a point in time. Because of the availability of international diversification, a well
diversified portfolio of U.S. stocks is inside the efficient frontier and is dominated by internationally
diversified portfolios. In other words, an investor holding a welldiversified portfolio of U.S. stocks
would be able to reduce risk by diversifying internationally without sacrificing expected return.
Section 2.2.1. The riskfree asset and the capital asset pricing model.
So far, we assumed that the investor could form her portfolio holding shares of IBM and
XYZ. Lets now assume that there is a third asset, an asset which has no risk over the investment
horizon of the investor. An example of such an asset would be a Treasury Bill, which we abbreviate
as Tbill. Tbills are discount bonds. Discount bonds are bonds where the interest payment comes
in the form of the capital appreciation of the bond. Hence, the bond pays par at maturity and sells for
less than par before maturity. Since they are obligations of the Federal government, Tbills have no
default risk. Consequently, they have a sure return if held to maturity since the gain to the holder is
par minus the price she paid for the Tbill. Consider the case where the oneyear Tbill has a yield of
5%. This means that our investor can earn 5% for sure by holding the Tbill. The box on Tbills
shows how they are quoted and how one can use a quote to obtain a yield.
By having an asset allocation where she invests some of her money in the Tbill, the investor
can decrease the volatility of her endofyear wealth. For instance, our investor could put half of her
money in Tbills and the other half in the portfolio on the frontier with the smallest volatility. This
minimumvolatility portfolio has an expected return of 15.6% and a standard deviation of 26.83%.
As a result (using our formulas for the expected return and the volatility of a portfolio), her portfolio
22
would have a volatility of 13.42% and an expected return of 12.8%. All combinations of the
minimumvolatility portfolio and the riskfree asset lie on a straight line that intersects the efficient
frontier at the minimumvolatility portfolio. Portfolios on that straight line to the left of the minimum
volatility portfolio have positive investments in the riskfree asset. To the right of the minimum
volatility portfolio, the investor borrows to invest in stocks. Figure 2.6. shows this straight line.
Figure 2.6. suggests that the investor could do better by combining the riskfree asset with a portfolio
more to the right on the efficient frontier than the minimumvolatility portfolio because then all
possible combinations would have a higher return. However, the investor cannot do better than
combining the riskfree asset with portfolio m. This is because in that case the straight line is tangent
to the efficient frontier at m. There is no straight line starting at the riskfree rate that touches the
efficient frontier at least at one point and has a steeper slope than the line tangent to m. Hence, the
investor could not invest on a line with a steeper slope because she could not find a portfolio of
stocks to create that line!
There is a tangency portfolio irrespective of the universe of securities one uses to form the
efficient frontier as long as one can invest in a riskfree asset. We already saw, however, that investors
benefit from forming portfolios using the largest possible universe of securities. As long as investors
agree on the expected returns, volatilities, and covariances of securities, they end up looking at the
same efficient frontier if they behave optimally. In this case, our reasoning implies that they all want
to invest in portfolio m. This can only be possible if portfolio m is the market portfolio. The market
portfolio is a portfolio of all securities available with each portfolio share the fraction of the market
value of that security in the total capitalization of all securities or aggregate wealth. IBM is a much
smaller fraction of the wealth of investors invested in U.S. securities (on June 30, 1999, it was 2.09%
23
of the S&P500 index). Consequently, if the portfolio share of IBM is 10%, there is too much demand
for IBM given its expected return. This means that its expected return has to decrease so that
investors want to hold less of IBM. This process continues until the expected return of IBM is such
that investors want to hold the existing shares of IBM at the current price. Consequently, the demand
and supply of shares are equal for each firm when portfolio m is such that the portfolio of each
security in the portfolio corresponds to its market value divided by the market value of all securities.
If all investors have the same views on expected returns, volatilities, and covariances of
securities, all of them hold the same portfolio of risky securities, portfolio m, the market portfolio.
To achieve the right volatility for their invested wealth, they allocate their wealth to the market
portfolio and to the riskfree asset. Investors who have little aversion to risk borrow to invest more
than their wealth in the market portfolio. In contrast, the most riskaverse investors put most or all
of their wealth in the riskfree asset. Note that if investors have different views on expected returns,
volatilities and covariances of securities, on average, they still must hold portfolio m because the
market portfolio has to be held. Further, for each investor, there is always a tangency portfolio and
she always allocates her wealth between the tangency portfolio and the riskfree asset if she trades
off risk and return. In the case of investors who invest in the market portfolio, we know exactly their
reward for bearing volatility risk since the expected return they earn in excess of the riskfree rate is
given by the slope of the tangency line. These investors therefore earn (E(R
m
)  R
f
)/F
m
per unit of
volatility, where R
m
is the return of portfolio m, F
m
is its volatility, and R
f
is the riskfree rate. The
excess of the expected return of a security or of a portfolio over the riskfree rate is called the risk
premium of that security or portfolio. A risk premium on a security or a portfolio is the reward the
investor expects to receive for bearing the risk associated with that security or portfolio. E(R
m
)  R
f
24
is therefore the risk premium on the market portfolio.
Section 2.2.2. The risk premium for a security.
We now consider the determinants of the risk premium of an individual security. To start this
discussion, it is useful to go back to our example where we had N securities with uncorrelated
returns. As N gets large, a portfolio of these securities has almost no volatility. An investor who
invests in such a portfolio should therefore earn the riskfree rate. Otherwise, there would be an
opportunity to make money for sure if N is large enough. A strategy which makes money for sure
with a net investment of zero is called an arbitrage strategy. Suppose that the portfolio earns 10%
and the riskfree rate is 5%. Investing in the portfolio and borrowing at the riskfree rate earns five
cents per dollar invested in the portfolio for sure without requiring any capital. Such an arbitrage
strategy cannot persist because investors make it disappear by taking advantage of it. The only way
it cannot exist is if each security in the portfolio earns the riskfree rate. In this case, the risk of each
security in the portfolio is completely diversifiable and consequently no security earns a risk premium.
Now, we consider the case where a portfolio has some risk that is not diversifiable. This is
the risk left when the investor holds a diversified portfolio and is the only risk the investor cares
about. Because it is not diversifiable, such risk is common to many securities and is generally called
systematic risk. In the aggregate, there must be risk that cannot be diversified away because most
firms benefit as economic activity unexpectedly improves. Consequently, the risk of the market
portfolio cannot be diversified because it captures the risk associated with aggregate economic
fluctuations. However, securities that belong to the market portfolio can have both systematic risk
and risk that is diversifiable.
25
Cov(R R = Cov( w R R = w Cov(R R
p p i i p
N
i i p
i=1
N
, ) , ) , )
i=
1
The market portfolio has to be held in the aggregate. Consequently, since all investors who
invest in risky securities do so by investing in the market portfolio, expected returns of securities must
be such that our investor is content with holding the market portfolio as her portfolio of risky
securities. For the investor to hold a security that belongs to the market portfolio, it has to be that the
risk premium on that security is just sufficient to induce her not to change her portfolio. This means
that the change in the portfolios expected return resulting from a very small increase in the investors
holdings of the security must just compensate for the change in the portfolios risk. If this is not the
case, the investor will change her portfolio shares and will no longer hold the market portfolio.
To understand how the risk premium on a security is determined, it is useful to note that the
formula for the variance of the return of an arbitrary portfolio, R
p
, can be written as the portfolio
share weighted sum of the return covariances of the securities in the portfolio with the portfolio. To
understand why this is so, remember that the return covariance of a security with itself is the return
variance of that security. Consequently, the variance of the return of a portfolio can be written as the
return covariance of the portfolio with itself. The return of the portfolio is a portfolio share weighted
sum of the returns of the securities. Therefore, the variance of the return of the portfolio is the
covariance of the portfolio share weighted sum of returns of the securities in the portfolio with the
return of the portfolio. Since the covariance of a sum of random variables with R
p
is equal to the sum
of the covariances of the random variables with R
p
, it follows that the variance of the portfolio returns
is equal to a portfolio share weighted sum of the return covariances of the securities with the portfolio
return:
(2.4.)
26
Consequently, the variance of the return of a portfolio is a portfolio share weighted average of the
covariances of the returns of the securities in the portfolio with the return of the portfolio. Equation
(2.4.) makes clear that a portfolio is risky to the extent that the returns of its securities covary with
the return of the portfolio.
Lets now consider the following experiment. Suppose that security z in the market portfolio has
a zero return covariance with the market portfolio, so that Cov(R
z
,R
m
) = 0. Now, lets decrease
slightly the portfolio share of security z and increase by the same decimal amount the portfolio share
of security i. Changing portfolio shares has a feedback effect: Since it changes the distribution of the
return of the portfolio, the return covariance of all securities with the portfolio is altered. If the
change in portfolio shares is small enough, the feedback effect becomes a secondorder effect and can
be ignored. Consequently, as we change the portfolio shares of securities i and z, none of the
covariances change in equation (2.4.). By assumption, the other portfolio shares are kept constant.
Letting the change in portfolio share of security i be ), so that the portfolio share after the change
is w
i
+ ), the impact on the volatility of the portfolio of the change in portfolio shares is therefore
equal to )cov(R
i
,R
p
)  )cov(R
z
,R
p
). Since Cov(R
z
,R
p
) is equal to zero, increasing the portfolio share
of security i by ) and decreasing the portfolio share of security z by ) therefore changes the volatility
of the portfolio by )cov(R
i
,R
p
). Security i can have a zero, positive, or negative return covariance
with the portfolio. Lets consider each case in turn:
1) Security i has a zero return covariance with the market portfolio. In this case, the
volatility of the portfolio return does not change if we increase the holding of security i at the expense
of the holding of security z. Since the risk of the portfolio is unaffected by our change, the expected
27
return of the portfolio should be unaffected, so that securities z and i must have the same expected
return. If the two securities have a different expected return, the investor would want to change the
portfolio shares. For instance, if security z has a higher expected return than security i, the investor
would want to invest more in security z and less in security i. In this case, she would not hold the
market portfolio anymore, but every other investor would want to make the same change so that
nobody would hold the market portfolio.
2) Security i has a positive covariance with the market portfolio. Since security i has a
positive return covariance with the portfolio, it is more likely to have a good (bad) return when the
portfolio has a good (bad) return. This means holding more of security i will tend to increase the
good returns of the portfolio and worsen the bad returns of the portfolio, thereby increasing its
volatility. This can be verified by looking at the formula for the volatility of the portfolio return: By
increasing the portfolio share of security i and decreasing the portfolio share of security z, we increase
the weight of a security with a positive return covariance with the market portfolio and thereby
increase the weighted sum of the covariances. If security z is expected to earn the same as security
i, the investor would want to sell security i to purchase more of security z since doing so would
decrease the risk of the portfolio without affecting its expected return. Consequently, for the investor
to be satisfied with its portfolio, security i must be expected to earn more than security z.
3) Security i has a negative return covariance with the market portfolio. In this case, the
reasoning is the opposite from the previous case. Adding more of security i to the portfolio reduces
the weighted sum of the covariances, so that security i has to have a lower expected return than
security z.
28
In equilibrium it must the case that no investor wants to change her security holdings. The
reasoning that we used leads to three important results that must hold in equilibrium:
Result I: A securitys expected return should depend only on its return covariance with
the market portfolio. Suppose that securities i and j have the same return covariance with the
market portfolio but different expected returns. A slight increase in the holding of the security that
has the higher expected return and decrease in the holding of the other security would create a
portfolio with a higher expected return than the market portfolio but with the same volatility. In that
case, no investor would want to hold the market portfolio. Consequently, securities l and j cannot
have different expected returns in equilibrium.
Result II: A security that has a zero return covariance with the market portfolio should
have an expected return equal to the return of the riskfree security. Suppose that this is not the
case. The investor can then increase the expected return of the portfolio without changing its volatility
by investing slightly more in the security with the higher expected return and slightly less in the
security with the lower expected return.
Result III: A securitys risk premium is proportional to its return covariance with the
market portfolio. Suppose that securities i and j have positive but different return covariances with
the market portfolio. If security i has k times the return covariance of security j with the market
portfolio, its risk premium must be k times the risk premium of security j. To see why this is true, note
that we can always combine security i and security z in a portfolio. Let h be the weight of security i
29
hCov(R , R ) (1 h)Cov(R , R ) Cov(R , R )
i m z m j m
+ =
in that portfolio and (1h) the weight of security z. We can choose h to be such that the portfolio of
securities i and z has the same return covariance with the market portfolio as security j:
(2.5.)
If h is chosen so that equation (2.5.) holds, the portfolio should have the same expected excess return
as security j since the portfolio and the security have the same return covariance with the market
portfolio. Otherwise, the investor could increase the expected return on her invested wealth without
changing its return volatility by investing in the security and shorting the portfolio with holdings of
securities i and z if the security has a higher expected return than the portfolio or taking the opposite
position if the security has a lower expected return than the portfolio. To find h, remember that the
return covariance of security z with the market portfolio is zero and that the return covariance of
security i with the market portfolio is k times the return covariance of security j with the market
portfolio. Consequently, we can rewrite equation (2.5.) as:
(2.6.) hCov(R R h)Cov(R R h * k *Cov(R R
i m z m j m
, ) ( , ) , ) + = 1
Therefore, by choosing h equal to 1/k so that h*k is equal to one, we choose h so that the
return covariance of the portfolio containing securities z and i with the market portfolio is the same
as the return covariance with the market portfolio of security j. We already know from the Second
Result that security z must earn the riskfree rate. From the First Result, it must therefore be that the
portfolio with portfolio share h in security i and (1h) in security z has the same expected return as
30
hE(R ) (1 h)R E(R )
i f j
+ =
security j:
(2.7.)
If we subtract the riskfree rate from both sides of this equation, we have h times the risk premium
of security j on the lefthand side and the risk premium of security j on the righthand side. Dividing
both sides of the resulting equation by h and remembering that h is equal to 1/k, we obtain:
(2.8.)
[ ]
E(R R k E(R R
i f j f
) ) =
Consequently, the risk premium on security i is k times the risk premium on security j as
predicted. By definition, k is the return covariance of security i with the market portfolio divided by
the return covariance of security j with the market portfolio. Replacing k by its definition in the
equation and rearranging, we have:
(2.9.)
[ ]
E(R R
Cov(R R
Cov(R R
E(R R
i f
i m
j m
j f
)
, )
, )
) =
This equation has to apply if security j is the market portfolio. If it does not, one can create a security
that has the same return covariance with the market portfolio as the market portfolio but a different
expected return. As a result, the investor would increase her holding of that security and decrease her
holding of the market portfolio if that security has a higher expected return than the market portfolio.
The return covariance of the market portfolio with itself is simply the variance of the return of the
market portfolio. Lets choose security j to be the market portfolio in our equation. Remember that
31
[ ] [ ] E(R R = w E(R R w E(R R
pf f i i f
i=1
N
i m f
) ) ) =
i
in our analysis, security i has a return covariance with the market portfolio that is k times the return
covariance of security j with the market portfolio. If security j is the market portfolio, its return
covariance with the market portfolio is the return variance of the market portfolio. When security j
is the market portfolio, k is therefore equal to Covariance(R
i
,R
m
)/Variance(R
m
), which is called
security is beta, or $
i
. In this case, our equation becomes:
Capital asset pricing model
(2.10.)
[ ]
E(R  R = E(R  R
i f i m f
) )
The capital asset pricing model (CAPM) tells us how the expected return of a security is
determined. The CAPM states that the expected excess return of a risky security is equal to the
systematic risk of that security measured by its beta times the markets risk premium. Importantly,
with the CAPM diversifiable risk has no impact on a securitys expected excess return. The relation
between expected return and beta that results from the CAPM is shown in figure 2.7.
Our reasoning for why the CAPM must hold with our assumptions implies that the CAPM
must hold for portfolios. Since a portfolios return is a portfolio share weighted average of the return
of the securities in the portfolio, the only way that the CAPM does not apply to a portfolio is if it does
not apply to one or more of its constituent securities. We can therefore multiply equation (2.10.) by
the portfolio share and add up across securities to obtain the expected excess return of the portfolio:
The portfolio share weighted sum of the securities in the portfolio is equal to the beta of the portfolio
32
w
Cov(R R
Var(R
=
Cov(w R R
Var(R
=
Cov( w R R
Var(R
=
Cov(R R
Var(R
=
i
i m
m i=1
N
i i m
m i=1
N i i
N
m
m
p m
m
p
, )
)
, )
)
, )
)
, )
)
= i 1
obtained by dividing the return covariance of the portfolio with the market with the return variance
of the market. This is because the return covariance of the portfolio with the market portfolio is the
portfolio share weighted average of the return covariances of the securities in the portfolio:
To see how the CAPM model works, suppose that the riskfree rate is 5%, the market risk premium
is 6% and the $ of IBM is 1.33. In this case, the expected return of IBM is:
Expected return of IBM = 5% + 1.33*[6%] = 13%
This is the value we used earlier for IBM. The box on the CAPM in practice shows how
implementing the CAPM for IBM leads to the above numbers.
Consider a portfolio worth one dollar that has an investment of $1.33 in the market portfolio
and $0.33 in the riskfree asset. The value of the portfolio is $1, so that the portfolio share of the
investment in the market is (1.33/1) and the portfolio share of the investment in the riskfree asset is
(0.33/1). The beta of the market is one and the beta of the riskfree asset is zero. Consequently, this
portfolio has a beta equal to the portfolio share weighted average of the beta of its securities, or
(1.33/*1)*1 + ( 0.33/1)*0 =1.33, which is the beta of IBM. If the investor holds this portfolio, she
has the same systematic risk and therefore ought to receive the same expected return as if she had
invested a dollar in IBM. The actual return on IBM will be the return of the portfolio plus
33
diversifiable risk that does not affect the expected return. The return of the portfolio is R
F
+ 1.33(R
m
 R
F
). The return of IBM is R
F
+ 1.33(R
m
 R
F
) plus diversifiable risk whose expected value is zero.
If IBM is expected to earn more than the portfolio, then the investor can make an economic profit
by holding IBM and shorting the portfolio. By doing this, she invests no money of her own and bears
no systematic risk, yet earns a positive expected return corresponding to the difference between the
expected return of the portfolio and of IBM.
Section 2.3. Diversification and risk management.
We now discuss how an investor values a firm when the CAPM holds. Once we understand
this, we can find out when risk management increases firm value. For simplicity, lets start with a firm
that lives one year only and is an allequity firm. At the end of the year, the firm has a cash flow of
C and nothing else. The cash flow is the cash generated by the firm that can be paid out to
shareholders. The firm then pays that cash flow to equity as a liquidating dividend. Viewed from
today, the cash flow is random. The value of the firm today is the present value of receiving the cash
flow in one year. We denote this value by V. To be specific, suppose that the firm is a gold mining
firm. It will produce 1M ounces of gold this year, but after that it cannot produce gold any longer and
liquidates. For simplicity, the firm has no costs and taxes are ignored. Markets are assumed to be
perfect. At the end of the year, the firm makes a payment to its shareholders corresponding to the
market value of 1M ounces of gold.
If the firm is riskless, its value V is the cash flow discounted at the riskfree rate, C/(1+R
f
).
For instance, if the gold price is fixed at $350 an ounce and the riskfree rate is 5%, the value of the
firm is $350M/(1+0.05) or $333.33M. The reason for this is that one can invest $333.33M in the risk
34
free asset and obtain $350M at the end of the year. Consequently, if firm value differs from
$333.33M, there is an arbitrage opportunity. Suppose that firm value is $300m and the firm has one
million shares. Consider an investor who buys a share and finances the purchase by borrowing. At
maturity, she has to repay $300(1+0.05), or $315 and she receives $350, making a sure profit of $35
per share. If firm value is more than the present value of the cash flow, investors make money for sure
by selling shares short and investing the proceeds in the riskfree asset.
Lets now consider the case where the cash flow is random. In our example, this is because
the price of gold is random. The return of a share is the random liquidating cash flow C divided by
the firm value at the beginning of the year, V, minus one. Since C is equal to a quantity of gold times
the price of gold, the return is perfectly correlated with the return on an ounce of gold so that the firm
must have the same beta as gold. We know from the CAPM that any financial asset must have the
same expected return as the expected return of a portfolio invested in the market portfolio and in the
riskfree asset that has the same beta as the financial asset. Suppose, for the sake of illustration, that
the beta of gold is 0.5. The expected return on a share of the firm has to be the expected return on
a portfolio with a beta of 0.5. Such a portfolio can be constructed by investing an amount equal to
half the value of the share in the market portfolio and the same amount in the riskfree asset. If the
firm is expected to earn more than this portfolio, investors earn an economic profit by investing in the
firm and financing the investment in the firm by shorting the portfolio since they expect to earn an
economic profit without taking on any systematic risk. This strategy has risk, but that risk is
diversifiable and hence does not matter for investors with diversified portfolios.
We now use this approach to value the firm. Shareholders receive the cash flow in one year
for an investment today equal to the value of the firm. This means that the cash flow is equal to the
35
[ ]
E(C)
1 R E(R ) R
V
f M F
+ +
=
E(C)
1+ R E(R R
M
1+ 0.05 + 0.5(0.06)
M
f M f
+
= =
[ ) ]
$350
$324.074
value of the firm times one plus the rate of return of the firm. We know that the expected return of
the firm has to be given by the CAPM equation, so that it is the riskfree rate plus the firms beta
times the risk premium on the market. Consequently, firm value must be such that:
(2.12.)
[ ] ( )
E(C) V 1 R E(R ) R
f m f
= + +
If we know the distribution of the cash flow C, the riskfree rate R
f
, the $ of the firm, and the risk
premium on the market E(R
M
)  R
f
, we can compute V because it is the only variable in the equation
that we do not know. Solving for V, we get:
(2.13.)
Using this formula, we can value our gold mining firm. Lets say that the expected gold price is $350.
In this case, the expected payoff to shareholders is $350M, which is one million ounces times the
expected price of one ounce. As before, we use a riskfree rate of 5% and a risk premium on the
market portfolio of 6%. Consequently:
We therefore obtain the value of the firm by discounting the cash flow to equity at the expected return
required by the CAPM. Our approach extends naturally to firms expected to live more than one year.
The value of such a firm for its shareholders is the present value of the cash flows to equity. Nothing
else affects the value of the firm for its shareholders  they only care about the present value of cash
36
the firm generates over time for them. We can therefore value equity in general by computing the sum
of the present values of all future cash flows to equity using the approach we used above to value one
such future cash flow. For a levered firm, one will often consider the value of the firm to be the sum
of debt and equity. This simply means that the value of the firm is the present value of the cash flows
to the debt and equity holders.
Cash flow to equity is computed as net income plus depreciation and other noncash charges
minus investment. To get cash flow to the debt and equity holders, one adds to cash flow to equity
the payments made to debt holders. Note that the cash flow to equity does not necessarily correspond
each year to the payouts to equity. In particular, firms smooth dividends. For instance, a firm could
have a positive cash flow to equity in excess of its planned dividend. It would then keep the excess
cash flow in liquid assets and pay it to shareholders later. However, all cash generated by the firm
after debt payments belongs to equity and hence contributes to firm value whether it is paid out in a
year or not.
Section 2.3.1. Risk management and shareholder wealth.
Consider now the question we set out to answer in this chapter: Would shareholders want
a firm to spend cash to decrease the volatility of its cash flow when the only benefit of risk
management is to decrease share return volatility? Lets assume that the shareholders of the firm are
investors who care only about the expected return and the volatility of their wealth invested in
securities, so that they are optimally diversified and have chosen the optimal level of risk for their
portfolios. We saw in the previous section that the volatility of the return of a share can be
decomposed into systematic risk, which is not diversifiable, and other risk, unsystematic risk, which
37
is diversifiable. We consider separately a risk management policy that decreases unsystematic risk and
one that decreases systematic risk. A firm can reduce risk through financial transactions or through
changes in its operations. We first consider the case where the firm uses financial risk management
and then discuss how our reasoning extends to changes in the firms operations to reduce risk.
1) Financial risk management policy that decreases the firms unsystematic risk.
Consider the following situation. A firm has a market value of $1 billion. Suppose that its
management can sell the unsystematic risk of the firms shares to an investment bank by paying
$50M. We can think of such a transaction as a hedge offered by the investment bank which exactly
offsets the firms unsystematic risk. Would shareholders ever want the firm to make such a payment
when the only benefit to them of the payment is to eliminate the unsystematic risk of their shares? We
already know that firm value does not depend on unsystematic risk when expected cash flow is given.
Consider then a risk management policy eliminating unsystematic risk that decreases expected cash
flow by its cost but has no other impact on expected cash flow. Since the value of the firm is the
expected cash flow discounted at the rate determined by the systematic risk of the firm, this risk
management policy does not affect the rate at which cash flow is discounted. In terms of our
valuation equation, this policy decreases the numerator of the valuation equation without a change
in the denominator, so that firm value decreases.
Shareholders are diversified and do not care about diversifiable risks. Therefore, they are not
willing to discount expected cash flow at a lower rate if the firm makes cash flow less risky by
eliminating unsystematic risk. This means that if shareholders could vote on a proposal to implement
risk management to decrease the firms diversifiable risk at a cost, they would vote no and refuse to
incur the cost as long as the only effect of risk management on expected cash flow is to decrease
38
expected cash flow by the cost of risk management. Managers will therefore never be rewarded by
shareholders for decreasing the firms diversifiable risk at a cost because shareholders can eliminate
the firms diversifiable risk through diversification at zero cost. For shareholders to value a decrease
in unsystematic risk, it has to increase their wealth and hence the share price.
2) Financial risk management policy that decreases the firms systematic risk. We now
evaluate whether it is worthwhile for management to incur costs to decrease the firms systematic risk
through financial transactions. Consider a firm that decides to reduce its beta. Its only motivation for
this action is that it believes that it will make its shares more attractive to investors. The firm can
easily reduce its beta by taking a short position in the market since such a position has a negative beta.
The proceeds of the short position can be invested in the riskfree asset. This investment has a beta
of zero. In our discussion of IBM, we saw that a portfolio of $1.33 invested in the market and of
$0.33 borrowed in the riskfree asset has the same beta as an investment of one dollar invested in the
market. Consequently, if IBM was an allequity firm, the management of IBM could make IBM a
zero beta firm by selling short $1.33 of the market and investing the proceeds in the riskfree asset
for each dollar of market value. Would investors be willing to pay for IBM management to do this?
The answer is no because the action of IBMs management creates no value for its shareholders. In
perfect financial markets, a shareholder could create a zero beta portfolio long in IBM shares, short
in the market, and long in the riskfree asset. Hence, the investor would not be willing to pay for the
management of IBM to do something for her that she could do at zero cost on her own.
Remember that investors are assumed to be optimally diversified. Each investor chooses her
optimal asset allocation consisting of an investment in the riskfree asset and an investment in the
market portfolio. Consequently, if IBM were to reduce its beta, this means that the portfolio that
39
investors hold will have less risk. However, investors wanted this level of risk because of the reward
they expected to obtain in the form of a higher expected return. As IBM reduces its beta, therefore,
investors no longer hold the portfolio that they had chosen. They will therefore want to get back to
that portfolio by changing their asset allocation. In perfect financial markets, investors can costlessly
get back to their initial asset allocation by increasing their holdings of the risky portfolio and
decreasing their holdings of the safe asset. They would therefore object if IBM expended real
resources to decrease its beta. It follows from this discussion that investors choose the level of risk
of their portfolio through their own asset allocation. They do not need the help of firms whose shares
they own for that purpose.
Comparing our discussion of the reduction in unsystematic risk with our discussion of the
reduction in systematic risk creates a paradox. When we discussed the reduction in unsystematic risk,
we argued that shareholders cannot gain from a costly reduction in unsystematic risk undertaken for
the sole purpose of decreasing the return volatility because such a reduction decreases the numerator
of the present value formula without affecting the denominator. Yet, the reduction in systematic risk
obviously decreases the denominator of the present value formula for shares since it decreases the
discount rate. Why is it then that decreasing systematic risk does not increase the value of the shares?
The reason is that decreasing systematic risk has a cost, in that it decreases expected cash flow. To
get rid of its systematic risk, IBM has to sell short the market. Selling short the market earns a
negative risk premium since holding the market long has a positive risk premium. Hence, the expected
cash flow of IBM has to fall by the risk premium of the short sale. The impact of the short sale on
firm value is therefore the sum of two effects. The first effect is the decrease in expected cash flow
and the second is the decrease in the discount rate. The two effects cancel out. They have to for a
40
simple reason. Going short the market is equivalent to getting perfect insurance against market
fluctuations. In perfect markets, insurance is priced at its fair value. This means that the risk premium
IBM would earn by not changing its systematic risk has to be paid to whoever will now bear this
systematic risk. Hence, financial risk management in this case just determines who bears the
systematic risk, but IBMs shareholders charge the same price for market risk as anybody else since
that price is determined by the CAPM. Consequently, IBM management cannot create value by
selling market risk to other investors at the price that shareholders would require to bear that risk.
We have focused on financial risk management in our reasoning. A firm could change its
systematic risk or its unsystematic risk by changing its operations. Our reasoning applies in this case
also, but with a twist. Lets first look at unsystematic risk. Decreasing unsystematic risk does not
make shareholders better off if the only benefit of doing so is to reduce share return volatility. It does
not matter therefore whether the decrease in share volatility is due to financial transactions or to
operating changes. In contrast, if the firm can change its operations costlessly to reduce its beta
without changing its expected cash flow, firm value increases because expected cash flow is
discounted at a lower rate. Hence, decreasing cash flow beta through operating changes is worth it
if firm value increases as a result. On financial markets, every investor charges the same for systematic
risk. This means that nobody can make money from selling systematic risk to one group of investors
instead of another. The ability to change an investments beta through operating changes depends on
technology and strategy. A firm can become more flexible so that it has less fixed costs in cyclical
downturns. This greater flexibility translates into a lower beta. If flexibility has low cost but a large
impact on beta, the firms shareholders are better off if the firm increases its flexibility. If greater
flexibility has a high cost, shareholders will not want it because having it will decrease share value.
41
Hedging that only reduces systematic or idiosyncratic risk for shareholders has no impact on
the value of the shares in our analysis. This is because when the firm reduces risk, it is not doing
anything that shareholders could not do on their own equally well with the same consequences.
Shareholders can diversify to eliminate unsystematic risk and they can change their asset allocation
between the riskfree investment and the investment in the market to get the systematic risk they want
to bear. With our assumption of perfect markets, risk management just redistributes risk across
investors who charge the same price for bearing it. For risk management to create value for the firm,
the firm has to transfer risks to investors for whom bearing these risks is less expensive than it is for
the firm. With the assumptions of this section, this cannot happen. Consequently, for this to happen,
there must exist financial market imperfections.
Section 2.3.2. Risk management and shareholder clienteles.
In the introduction, we mentioned that one gold firm, Homestake, had for a long time a policy
of not hedging at all. Homestake justified its policy as follows in its 1990 annual report (p. 12):
So that its shareholders might capture the full benefit of increases in the price of gold,
Homestake does not hedge its gold production. As a result of this policy, Homestakes
earnings are more volatile than those of many other gold producers. The Company believes
that its shareholders will achieve maximum benefit from such a policy over the longterm.
The reasoning in this statement is that some investors want to benefit from gold price movements and
that therefore giving them this benefit increases firm value. These investors form a clientele the firm
42
caters to. Our analysis so far does not account for the possible existence of clienteles such as
investors wanting to bear gold price risks. With the CAPM, investors care only about their portfolios
expected return and volatility. They do not care about their portfolios sensitivity to other variables,
such as gold prices. However, the CAPM has limitations in explaining the returns of securities. For
instance, small firms earn more on average than predicted by the CAPM. It is possible that investors
require a risk premium to bear some risks other than the CAPMs systematic risk. For instance, they
might want a risk premium to bear inflation risk. The existence of such risk premia could explain why
small firms earn more on average than predicted by the CAPM. It could be the case, then, that
investors value gold price risk. To see the impact of additional risk premia besides the market risk
premium on our reasoning about the benefits of hedging, lets suppose that Homestake is right and
that investors want exposures to specific prices and see what that implies for our analysis of the
implications of hedging for firm value.
For our analysis, lets consider explicitly the case where the firm hedges its gold price risk
with a forward contract on gold. We denote by Q the firms production and by G the price of gold
in one year. There is no uncertainty about Q.
Lets start with the case where there is no clientele effect to have a benchmark. In this case,
the CAPM applies. Empirically, gold has a beta close to zero. Suppose now for the sake of argument
that the gold beta is actually zero. In this case, all the risk of the gold producing firm is diversifiable.
This means that hedging does not affect the gold firms value if our analysis is right. Lets make sure
that this is the case. The firm eliminates gold price risk by selling gold forward at a price F per unit,
the forward price. In this case, the value of the cash flow to shareholders when the gold is sold is FQ,
which is known today. Firm value today is FQ discounted at the riskfree rate. If the firm does not
43
hedge, the expected cash flow to shareholders is E(G)Q. In this case, firm value is obtained by
discounting E(G)Q at the riskfree rate since there is no systematic risk. The difference between the
hedged value of the firm and its unhedged value is [F  E(G)]Q/(1 + R
f
). With our assumptions, the
hedged firm is worth more than the unhedged firm if the forward price exceeds the expected spot
price, which is if F  E(G) is positive. Remember that with a short forward position we receive F for
delivering gold worth G per ounce. F  E(G) is therefore equal to the expected payoff from selling
one ounce of gold forward at the price F. If this expected payoff is positive, it means that one expects
to make a profit on a short forward position without making an investment since opening a forward
contract requires no cash. The only way we can expect to make money without investing any of our
own in the absence of arbitrage opportunities is if the expected payoff is a reward for bearing risk.
However, we assumed that the risk associated with the gold price is diversifiable, so that F  G
represents diversifiable risk. The expected value of F  G has to be zero, since diversifiable risk does
not earn a risk premium. Consequently, FQ = E(G)Q and hedging does not affect the firms value.
Consider now the case where gold has a positive beta. By taking a long forward position in
gold which pays G  F, one takes on systematic risk. The only way investors would enter such a
position is if they are rewarded with a risk premium, which means that they expect to make money
out of the long forward position. Hence, if gold has systematic risk, it must be that E(G) > F, so that
the expected payout to shareholders is lower if the firm hedges than if it does not. If the firm is
hedged, the cash flow has no systematic risk and the expected cash flow is discounted at the riskfree
rate. If the firm is not hedged, the cash flow has systematic risk, so that the higher expected cash flow
of the unhedged firm is discounted at a higher discount rate than the lower expected cash flow of the
hedged firm. The lower discount rate used for the unhedged firm just offsets the fact that expected
44
cash flow is lower for the hedged firm, so that the present value of expected cash flow is the same
whether the firm hedges or not. An investor today must be indifferent between paying FQ in one year
or receiving GQ at that time. Otherwise, the forward contract has a value different from zero since
the payoff to a long forward position to buy Q units of gold is GQ  FQ, which cannot be the case.
Hence, the present value of FQ and of GQ must be the same.
The argument extends naturally to the case where some investors value exposure to gold for
its own sake. Since investors value exposure to gold, they are willing to pay for it and hence the risk
premium attached to gold price risk is lower than predicted by the CAPM. This means that exposure
to gold lowers the discount rate of an asset relative to what it would be if exposure to gold was not
valuable to some investors. Consequently, investors who want exposure to gold bid up forward prices
since forward contracts enable these investors to acquire exposure to gold. If the firm does not hedge,
its share price reflects the benefit from exposure to gold that the market values because its discount
rate is lower. In contrast, if the firm hedges, its shareholders are no longer exposed to gold. However,
to hedge, the firm sells exposure to gold to investors by enabling them to take long positions in
forward contracts. Consequently, the firm earns a premium for selling exposure to gold that increases
its expected cash flow. Hence, shareholders can earn the premium for gold exposure either by having
exposure to gold and thereby lowering the discount rate that applies to the firms cash flow or by
selling exposure to gold and earning the risk premium that accrues to short forward positions. The
firm has a natural exposure to gold and it is just a matter of which investors bear it. In our reasoning,
it does not matter whether the firms shareholders themselves are shareholders who value gold
exposure or not. If the firm gets rid of its gold exposure, the firms shareholders can buy it on their
own. Irrespective of how investors who value gold exposure get this exposure, they will have to pay
45
the same price for it since otherwise the same good  gold exposure  would have different prices on
the capital markets, making it possible for investors to put on arbitrage trades that profit from these
price differences. As a result, if the firms shareholders value gold exposure, they will get it one way
or another, but they will always pay the same price for it which will make them indifferent as to where
they get it.
An important lesson from this analysis is that the value of the firm is the same whether the firm
hedges or not irrespective of how the forward price is determined. This lesson holds because there
are arbitrage opportunities if hedging creates value with our assumptions. Suppose that firm value
for the hedged firm is higher than for the unhedged firm. In this case, an investor can create a share
of the hedged firm on his own by buying a share of the unhedged firm and selling one ounce of gold
forward at the price F. His cash cost today is the price of a share since the forward position has no
cash cost today. Having created a share of the hedged firm through homemade hedging, the investor
can then sell the share hedged through homemade hedging at the price of the share of the hedged
firm. There is no difference between the two shares and hence they should sell for the same price.
Through this transaction, the investor makes a profit equal to the difference between the share price
of the hedged firm and the share price of the unhedged firm. This profit has no risk attached to it and
is, consequently, an arbitrage profit. Consequently, firm value must be the same whether the firm
hedges or not with our assumptions.
It follows from our analysis that the clientele argument of Homestake is not correct. With
perfect financial markets, anybody can get exposure to gold without the help of Homestake. For
instance, if Homestake can take a long forward position, so can investors. If Homestake increases its
value by hedging, then investors can buy the unhedged Homestake, create a hedged Homestake on
46
their own account with a forward transaction and sell it on the equity markets. On net, they make
money! This cannot be. Whenever investors can do on their own what the firm does, in other words,
whenever homemade hedging is possible, the firm cannot possibly contribute value through hedging.
Section 2.3.3. The risk management irrelevance proposition.
Throughout this section, we saw that the firm cannot create value by hedging risks when the
price of bearing these risks within the firm is the same as the price of bearing them outside of the firm.
In this chapter, the only cost of bearing risks within the firm is the risk premium attached to these
risks by the capital markets when they value the firm. The same risk premium is required by the
capital markets for bearing these risks outside the firm. Consequently, shareholders can alter the
firms risk on their own through homemade hedging at the same terms as the firm and the firm has
nothing to contribute to the shareholders welfare through risk management. Lets make sure that this
is the case:
1) Diversifiable risk. It does not affect the share price and investors do not care about it
because it gets diversified within their portfolios. Hence, eliminating it does not affect firm value.
2) Systematic risk. Shareholders require the same risk premium for it as all investors. Hence,
eliminating it for the shareholders just means having other investors bear it at the same cost. Again,
this cannot create value.
3) Risks valued by investors differently than predicted by the CAPM. Again,
shareholders and other investors charge the same price for bearing such risks.
The bottom line from this can be summarized in the hedging irrelevance proposition:
47
Hedging irrelevance proposition. Hedging a risk does not increase firm value when the cost
of bearing the risk is the same whether the risk is born within the firm or outside the firm by the
capital markets.
Section 2.4. Risk management by investors.
We saw so far that firms have no reason to adopt risk management policies to help investors
manage their portfolio risks when investors are welldiversified. We now consider whether investors
have reasons to do more than simply diversify and allocate their wealth between the market portfolio
and the riskfree asset optimally. Lets go back to the investor considered in the first section. Suppose
that investor does not want to take the risk of losing more than $50,000. For such an investor, the
only solution given the approach developed so far would be to invest in the riskfree asset at least the
present value of $50,000 invested at the riskfree rate. In one year, this investment would then
amount to $50,000. At the riskfree rate of 7%, this amounts to $46,729. She can then invest the rest
in the market, so her investment in the market is $52,271. With this strategy, the most the investor
can gain for each 1% return in the market is $522.71. The investor might want more exposure to the
market.
To get a different exposure to the market, the investor could create a levered position in
stocks. However, as soon as she borrows to invest more in the market, she takes the risk of ending
up with a loss on her levered position so that she has less than $50,000 at the end of the year. A static
investment strategy is one that involves no trades between the purchase of a portfolio and the time
the portfolio is liquidated. The only static investment strategy which guarantees that the investor will
have $50,000 at the end of the year but benefits more if the market increases than an investment in
48
the market of $52,271 is a strategy that involves buying call options.
Consider the following strategy. The investor invests $100,000 in the market portfolio minus
the cost of buying a put with an exercise price at $50,000. With this strategy, the investor has an
exposure to the market which is much larger than $50,000. The exact amount of the exposure
depends on the cost of the put. However, a put on an investment in the market at $100,000 with an
exercise price of $50,000 will be extremely cheap  less than one hundred dollars because the
probability of the market losing 50% is very small. Consequently, the investor can essentially invest
$100,000 in the market and eliminate the risk of losing more than $50,000. She could not achieve this
payoff with a static investment strategy without using derivatives. Using derivatives, the investor
could achieve lots of different payoffs. For instance, she could buy a call option on a $100,000
investment in the market portfolio with an exercise price of $100,000 and invest the remainder in the
riskfree asset. As long as the volatility of the market portfolio is not too high, this strategy
guarantees wealth in excess of $100,000 at the end of the year and participation in the market
increases from the current level equal to an investment in the market of $100,000. Such a strategy
is called a portfolio insurance strategy in that it guarantees an amount of wealth at the end of the
investment period at least equal to the current wealth. In chapter 13, we will see exactly how to
implement portfolio insurance.
Derivatives enable investors to achieve payoffs that they could not achieve otherwise. They
can also allow them to take advantage of information in ways that they could not otherwise. The
concept of market efficiency means that all public information is incorporated in prices. However, it
does not preclude that an investor might disagree with the market or have information that the market
does not have. Such an investor might then use derivatives to take advantage of her views.
49
Suppose, for instance, that our investor believes that it is highly likely that IBM will exceed $120 in
one year when it is $100 currently. If she feels that this outcome is more likely than the market thinks
it is, she can capitalize on her view by buying a call option with exercise price at $120. Even more
effectively, she might buy an exotic derivative such as a digital cash or nothing call with exercise price
at $120. This derivative pays off a fixed amount if and only if the price of the underlying exceeds the
exercise price. Suppose that this digital pays $100,000 if IBM exceeds $120. The digital pays all of
its promised payment if IBM sells for $120.01. In contrast, a call on a share of IBM with exercise
price of $120 pays only one cent if IBM is at $120.01. Consequently, the digital call is a more
effective option to take advantage of the view that there is an extremely high probability that IBM
will be above $120 in one year when one does not know more than that.
An important use of risk management by investors occurs when investors have information
that leads them to want to hold more of some securities than the market portfolio. For instance, our
investor might believe that IBM is undervalued, which makes its purchase attractive. If our investor
puts all her wealth in IBM to take advantage of her knowledge, she ends up with a portfolio that is
not at all diversified. To reduce the risk of her IBM position, she might decide to hedge the risks of
IBM that she can hedge. An obvious risk she can hedge is the market risk. She can therefore use a
derivative, such as an index futures contract, to hedge this risk. Another case where hedging is often
used is in international investment. An investor might believe that investing in a foreign country is
advantageous, but she feels that there is no reward to bearing foreign exchange risk. She can then use
derivatives to eliminate exchange rate risk.
This discussion shows that risk management can make individual investors better off. It can
allow investors to choose more appropriate payoff patterns from their investments, to hedge the risks
50
that they do not want to bear because they feel that the reward is too low, and to allow them to
capitalize more effectively on their views.
Section 2.5. Conclusion.
In this chapter, we first examined how investors evaluate the risk of securities. We saw how,
using a distribution function, one can evaluate the probability of various outcomes for the return of
a security. This ability we developed to specify the probability that a security will experience a return
smaller than some number will be of crucial importance throughout this book. We then saw that
investors can diversify and that this ability to diversify effects how they evaluate the riskiness of a
security. When holding a portfolio, an investor measures the riskiness of a security by its contribution
to the risk of the portfolio. Under some conditions, the best portfolio of risky securities an investor
can hold is the market portfolio. A securitys contribution to the risk of the market portfolio is its
systematic risk. A securitys unsystematic risk does not affect the riskiness of the portfolio. This
fundamental result allowed us to present the capital asset pricing model, which states that a securitys
risk premium is given by its beta times the risk premium on the market portfolio. The CAPM allowed
us to compute the value of future cash flows. We saw that only the systematic risk of cash flows
affects the rate at which expected future cash flows are discounted.
We then showed that in perfect financial markets, hedging does not affect firm value. We
showed that this is true for hedging through financial instruments systematic as well as unsystematic
risks. Further, we demonstrated that if investors have preferences for some types of risks, like gold
price risks, it is still the case that hedging is irrelevant in perfect financial markets. The reasoning was
straightforward and led to the hedging irrelevance proposition: if it costs the same for a firm to bear
51
a risk as it does for the firm to pay somebody else to bear it, hedging cannot increase firm value.
In the last section, we discussed when investors can be made better off using derivatives. This
is the case when diversification and asset allocation are not sufficient risk management tools. Such
a situation can arise, for instance, when the investor wants to construct a portfolio that requires no
trading after being put together, that guarantees some amount of wealth at some future date and yet
enables her to gain substantially from increases in the stock market. Such a portfolio is an insured
portfolio and it requires positions in options to be established. Though we saw how investors can be
made better off by using derivatives, we did not see how firms could increase their value through the
use of derivatives. The next chapter address this issue.
52
Literature Note
Much research examines the appropriateness of the assumption of the normal distribution for
security returns. Fama (1965) argues that stock returns are welldescribed by the normal distribution
and that these returns are independent across time. Later in this book, we will discuss some of the
issues raised in that research.
Fama (1970) presents the definitions of market efficiency and reviews the evidence. He
updated his review in Fama (1991). Over the recent past, several papers have questioned the
assumption that stock returns are independent across time. These papers examine the serial
correlation of stock returns. By serial correlation, we mean the correlation of a random variable
between two contiguous periods of equal length. Lo and McKinlay (1988) provide some evidence
of negative serial correlation for daily returns. Jegadeesh and Titman (1993) show that six month
returns have positive serial correlation. Finally, Fama and French (1988) find that returns measured
over periods of several years have negative serial correlation. This literature suggests that there is
some evidence that the distribution of returns depends on their recent history. Such evidence is
consistent with market efficiency if the recent history of stock returns is helpful to forecast the risk
of stocks, so that changes in expected returns reflect changes in risk. Later in this book, we will
discuss how to account for dependence in returns across time. None of the results of this chapter are
fundamentally altered. In particular, these results did not require the returns of IBM to be independent
across years. All they required was the distribution of the next years return to be normal.
The fundamental results on diversification and the CAPM were discovered respectively by
Markovitz (1952) and Sharpe (1964). Each of these authors was awarded a share of the Nobel
Memorial Prize in Economics in 1990. Textbooks on investments cover this material in much greater
53
details than we did here. Elton and Gruber provide an extensive presentation of portfolio theory. The
valuation theory using the CAPM is discussed in corporate finance textbooks or textbooks specialized
in valuation. For corporate finance textbooks, see Brealey and Myers (1999) or Jordan, Ross and
Westerfield. A book devoted to valuation is Copeland, Koller, and Murrin (1996).
The hedging irrelevance result is discussed in Smith and Stulz (1985). This result is a natural
extension of the leverage irrelevance result of Modigliani and Miller. They argue that in perfect
markets leverage cannot increase firm value. Their result led to the award of a Nobel Memorial Prize
in Economics in 1990 for Miller. Modigliani received such a Prize earlier for a different contribution.
Risk management in the gold industry has been the object of several papers and cases. The
firm American Barrick discussed in the introduction is the object of a Harvard Business School case.
Tufano (1996) compares the risk management practices of gold mining firms. His work is discussed
more in chapter 4.
One statement of the argument that foreign exchange hedging is advantageous for diversified
portfolios is Perold and Schulman (1988).
54
Key concepts
Cumulative distribution function, normal distribution, expected return, variance, covariance,
diversification, asset allocation, capital asset pricing model, beta, risk premium, homemade hedging,
risk management
55
Review questions
1. Consider a stock return that follows the normal distribution. What do you need to know to
compute the probability that the stocks return will be less than 10% over the coming year?
2. What are the three types of financial market efficiency?
3. What does diversification of a portfolio do to the distribution of the portfolios return?
4. What is beta?
5. When does beta measure risk?
6. For a given expected cash flow, how does the beta of the cash flow affects its current value?
7. How does hedging affect firm value if financial markets are perfect?
8. Why can hedging affect a firms expected cash flow when it does not affect its value?
9. Why is it that the fact that some investors have a preference for gold exposure does not mean that
a gold producing firm should not hedge its gold exposure.
10. What is the risk management irrelevance proposition?
56
11. How come risk management cannot be used to change firm value but can be used to change
investor welfare when financial markets are perfect?
57
Questions and exercises
1. The typical level of the monthly volatility of the S&P500 index is about 4%. Using a risk premium
of 0.5% and a riskfree rate of 5% p.a., what is the probability that a portfolio of $100,000 invested
in the S&P500 will lose $5,000 or more during the next month? How would your answer change if
you used current interest rates from Tbills?
2. During 1997, the monthly volatility on S&P500 increased to about 4.5% from its typical value of
4%. Using the current riskfree rate, construct a portfolio worth $100,000 invested in the S&P500
and the riskfree asset that has the same probability of losing $5,000 or more in a month when the
S&P500 volatility is 4.5% as $100,000 invested in the S&P500 when the S&P500 volatility is 4%.
3. Compute the expected return and the volatility of return of a portfolio that has a portfolio share
of 0.9 in the S&P500 and 0.1 in an emerging market index. The S&P500 has a volatility of return of
15% and an expected return of 12%. The emerging market has a volatility of return of 30% and an
expected return of 10%. The correlation between the emerging market index return and the S&P500
is 0.1.
4. If the S&P500 is a good proxy for the market portfolio in the CAPM and the CAPM applies to the
emerging market index, use the information in question 3 to compute the beta and risk premium for
the emerging market index.
58
5. Compute the beta of the portfolio described in question 4 with respect to the S&P500.
6. A firm has an expected cash flow of $500m in one year. The beta of the common stock of the firm
is 0.8 and this cash flow has the same risk as the firm as a whole. Using a riskfree rate of 6% and a
risk premium on the market portfolio of 6%, what is the present value of the cash flow. If the beta
of the firm doubles, what happens to the present value of the cash flow?
7. With the data used in the previous question, consider the impact on the firm of hedging the cash
flow against systematic risk. If management wants to eliminate the systematic risk of the cash flow
completely, how could it do so? How much would the firm have to pay investors to bear the
systematic risk of the cash flow?
8. Consider the situation you analyzed in question 6. To hedge the firms systematic risk, management
has to pay investors to bear this risk. Why is it that the value of the firm for shareholders does not fall
when the firm pays other investors to bear the systematic risk of the cash flow?
9. The management of a gold producing firm agrees with hedging irrelevance result and has
concluded that it applies to the firm. However, the CEO wants to hedge because the price of gold has
fallen over the last month. He asks for your advice. What do you tell him?
10. Consider again an investment in the emerging market portfolio discussed earlier. Now, you
consider investing $100,000 in that portfolio because you think it is a good investment. You decide
59
that you are going to ignore the benefits from diversification, in that all your wealth will be invested
in that portfolio. Your broker nevertheless presents you with an investment in a defaultfree bond in
the currency of the emerging country which matures in one year. The regression beta in a regression
of the dollar return of the portfolio on the return of the foreign currency bond is 1. The expected
return on the foreign currency bond is 5% in dollars and the volatility is 10%. Compute the expected
return of a portfolio with $100,000 in the emerging market portfolio, $50,000 in the foreign currency
bond, and $50,000 in the domestic riskfree asset which earns 5% per year. How does this portfolio
differ from the portfolio that has only an investment in the emerging market portfolio? Which one
would you choose and why? Could you create a portfolio with investments in the emerging market
portfolio, in the emerging market currency riskfree bond and in the riskfree asset which is has the
same mean but a lower volatility?
60
Figure 2.1. Cumulative probability function for IBM and for a stock with same return and
twice the volatility.
The expected return of IBM is 13% and its volatility is 30%. The horizontal line corresponds to a
probability of 0.05. The cumulative probability function of IBM crosses that line at a return almost
twice as high as the cumulative probability function of the riskier stock. There is a 5% chance that
IBM will have a lower return than the one corresponding to the intersection of the IBM cumulative
distribution function and the horizontal line, which is a return of 36%. There is a 5% change that the
stock with twice the volatility of IBM will have a return lower than 0.66%.
Stock with twice the volatility
Probability
Return in decimal form
IBM
61
Figure 2.2. Normal density function for IBM assuming an expected return of 13% and a
volatility of 30% and of a stock with the same expected return but twice the volatility.
This figure shows the probability density function of the oneyear return of IBM assuming an
expected return of 13% and a volatility of 30%. It also shows the probability density function of the
oneyear return of a stock that has the same expected return but twice the volatility of return of IBM.
Probability density
Probability density function of IBM
Probability density function
of the more volatile stock
Decimal return
62
Figure 2.3. Efficient frontier without a riskless asset. The function represented in the figure gives
all the combinations of expected return and volatility that can be obtained with investments in IBM
and XYZ. The point where the volatility is the smallest has an expected return of 15.6% and a
standard deviation of 26.83%. The portfolio on the upwardsloping part of the efficient frontier that
has the same volatility as a portfolio wholly invested in IBM has an expected return of 18.2%.
63
Figure 2.4. The benefits from diversification. This figure shows how total variance falls as more
securities are added to a portfolio. Consequently, 100% represents the variance of a typical U.S.
stock. As randomly chosen securities are added to the portfolio, its variance falls, but more so if the
stocks are chosen among both U.S. and nonU.S. stocks than only among U.S. stocks.
64
Figure 2.5. The efficient frontier using national portfolios. This figure shows the efficient frontier
estimated using the dollar monthly returns on country indices from 1980 to 1990.
65
Figure 2.6. Efficient frontier with a riskfree asset.
The function giving all the expected return and the volatility of all combinations of holdings in IBM
and XYZ is reproduced here. The riskfree asset has a return of 5%. By combining the riskfree asset
and a portfolio on the frontier, the investor can obtain all the expected return and volatility
combinations on the straight line that meets the frontier at the portfolio of risky assets chosen to form
these combinations. The figure shows two such lines. The line with the steeper slope is tangent to the
efficient frontier at portfolio m. The investor cannot form combinations of the riskfree asset and a
risky portfolio that dominate combinations formed from the riskfree asset and portfolio m.
Expected returns
Volatility
Portfolio m
66
Expected
return
Beta
1
R
E(R
m
)
The security
market line
Figure 2.7. The CAPM. The straight line titled the security market line gives the expected return
of a security for a given beta. This line intersects the vertical axis at the riskfree rate and has a value
equal to the expected return on the market portfolio for a beta of one.
67
Box: Tbills.
Tbills are securities issued by the U.S. government that mature in one year or less. They pay
no coupon, so that the investors dollar return is the difference between the price paid on sale or at
maturity and the price paid on purchase. Suppose that Tbills maturing in one year sell for $95 per
$100 of face value. This means that the holding period return computed annually is 5.26% (100*5/95)
because each investment of $95 returns $5 of interest after one year.
Exhibit 2.2.1. shows the quotes for Tbills provided by the Wall Street Journal. Tbills are
quoted on a bank discount basis. The price of a Tbill is quoted as a discount equal to:
D(t,t+n/365) = (360/n)(100P(t,t+n/365))
where D(t,t+n/365) is the discount for a Tbill that matures in n days and P(t,t+n/365) is the price of
the same Tbill. The bank discount method uses 360 days for the year. Suppose that the price of a
90day Tbill, P(t,t+90/365), is $98.5. In this case, the Tbill would be quoted at a discount of 6.00.
From the discount rate, one can recover the price using the formula:
P(t,t+n/365) = 100  (n/360)D(t,t+365/n)
For our example, we have 100  (90/360)6.00 = 98.5.
In the Wall Street Journal, two discounts are quoted for each bill, however. This is because
the dealers have to be compensated for their services. Lets look at how this works for the bill
maturing in 92 days. For that bill, there is a bid discount of 5.07 corresponding to a price of 98.7043
(100(92/360)5.07) and asked discount of 5.05 corresponding to a price 98.7096. The dealer buys
at the lower price and sells at the higher price. However, when the dealer quotes discounts, the higher
discount corresponds to the buy price and the lower discount corresponds to the price at which the
bidder sells. This is because to get the price one has to subtract the discount multiplied by the fraction
of 360 days the bill has left before it matures.
1
For a detailed analysis of the difference in the cost of capital between using a local and a global
index, see Stulz (1995).
68
Box: The CAPM in practice.
The CAPM provides a formula for the expected return on a security required by capital
markets in equilibrium. To implement the CAPM to obtain the expected return on a security, we need
to:
Step 1. Identify a proxy for the market portfolio.
Step 2. Identify the appropriate riskfree rate.
Step 3. Estimate the risk premium on the market portfolio.
Step 4. Estimate the $ of the security.
If we are trying to find the expected return of a security over the next month, the next year, or longer
in the future, all steps involve forecasts except for the first two steps. Using discount bonds of the
appropriate maturity, we can always find the riskfree rate of return for the next month, the next year,
or longer in the future. However, irrespective of which proxy for the market portfolio one uses, one
has to forecast its risk premium and one has to forecast the $ of the security.
What is the appropriate proxy for the market portfolio? Remember that the market portfolio
represents how the wealth of investors is invested when the assumptions of the CAPM hold. We
cannot observe the market portfolio directly and therefore we have to use a proxy for it. Most
applications of the CAPM in the U.S. involve the use of some broad U.S. index, such as the S&P500,
as a proxy for the market portfolio. As capital markets become more global, however, this solution
loses its appeal. Investors can put their wealth in securities all over the world. Hence, instead of
investing in the U.S. market portfolio, one would expect investors to invest in the world market
portfolio. Proxies for the U.S. market portfolio are generally highly correlated with proxies for the
world market portfolio, so that using the U.S. market portfolio in U.S. applications of the CAPM is
unlikely to lead to significant mistakes. However, in smaller countries, the market portfolio cannot
be the market portfolio of these countries. For instance, it would not make sense to apply the CAPM
in Switzerland using a Swiss index as a proxy for the market portfolio. Instead, one should use a
world market index, such as the Financial TimesGoldman Sachs World Index or the Morgan Stanley
Capital International Word Index.
1
Having chosen a proxy for the market portfolio, one has to estimate its risk premium.
Typically, applications of the CAPM use the past history of returns on the proxy chosen to estimate
the risk premium. The problem with doing so is that the resulting estimate of the risk premium
depends on the period of time one looks at. The table shows average returns for the U.S. market
portfolio in excess of the riskfree rate over various periods of time as well as average returns for the
world market portfolio in dollars in excess of the riskfree rate. Estimates of the risk premium used
in practice have decreased substantially over recent years. Many practitioners now use an estimate
of 6%.
How do we get $? Consider a security that has traded for a number of years. Suppose that
the relation between the return of that security and the return on the proxy for the market portfolio
is expected to be the same in the future as it was in the past. In this case, one can estimate $ over the
past and apply it to the future. To estimate $, one uses linear regression. To do so, one defines a
69
sample period over which one wants to estimate $. Typically, one uses five or six years of monthly
returns. Having defined the sample period, one estimates the following equation over the sample
period using regression analysis:
R
C
(t) = c + bR
M
(t) + e(t)
In this equation, e(t) is residual risk. It has mean zero and is uncorrelated with the return on the
market portfolio. Hence, it corresponds to idiosyncratic risk. The estimate for b will then be used as
the $ of the stock.
Let look at an example using data for IBM. We have data from January 1992 to the end of
September 1997, sixtynine observations in total. We use as the market portfolio the S&P500 index.
Using Excel, we can get the beta estimate for IBM using the regression program in data analysis
under tools (it has to be loaded first if it has not been done already). We use the return of IBM in
decimal form as the dependent or Y variable and the return on the S&P500 as the independent or X
variable. We use a constant in the regression. The Excel output is reproduced below. The estimates
are:
Return on IBM = 0.00123 + 1.371152*Return on S&P500
The standard error associated with the beta estimate is 0.33592. The difference between the beta
estimate and the unknown true beta is a normally distributed random variable with zero mean. Using
our knowledge about probabilities and the normal distribution, we can find that there is a 95% chance
that the true beta of IBM is between 0.7053 and 2.037004. The tstatistic is the ratio of the estimate
to its standard error. It provides a test here of the hypothesis that the beta of IBM is greater than
zero. A tstatistic greater than 1.65 means that we can reject this hypothesis in that there is only a 5%
chance or less that zero is in the confidence interval constructed around the estimate of beta. Here,
the tstatistic is 4.110271. This means that zero is 4.110271 standard errors from 1.371152. The
probability that the true beta would be that many standard errors below the mean is the pvalue
0.00011. As the standard error falls, the confidence interval around the coefficient estimates becomes
more narrow. Consequently, we can make stronger statements about the true beta. The Rsquare
coefficient of 0.201376 means that the return of the S&P500 explains a fraction 0.201376 of the
volatility of the IBM return. As this Rsquare increases, the independent variable explains more of
the variation in the dependent variable. As one adds independent variables in a regression, the R
square increases. The adjusted Rsquare takes this effect into account and hence is a more useful
guide of the explanatory power of the independent variables when comparing across regressions
which have different numbers of independent variables.
70
SUMMARY OUTPUT
Regression Statistics
Multiple R 0.44875
R Square 0.201376
Adjusted R
Square
0.189457
S t a n d a r d
Error
0.076619
Observations 69
Coefficients Standard
Error
tStat Pvalue
Intercept 0.00123 0.010118 0.12157 0.903604
X Variable 1.371152 0.333592 4.110271 0.00011
Chapter 3: Creating value with risk management
Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Section 3.1. Bankruptcy costs and costs of financial distress. . . . . . . . . . . . . . . . . . . . . . 4
Section 3.1.1. Bankruptcy costs and our present value equation. . . . . . . . . . . . . 6
Section 3.1.2. Bankruptcy costs, financial distress costs, and the costs of risk
management programs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9
Section 3.1.3. Bankruptcy costs and Homestake. . . . . . . . . . . . . . . . . . . . . . . . 10
Section 3.2. Taxes and risk management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Section 3.2.1. The tax argument for risk management. . . . . . . . . . . . . . . . . . . 16
1. Carrybacks and carryforwards . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
2. Tax shields . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
3. Personal taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17
Section 3.2.2. The tax benefits of risk management and Homestake . . . . . . . . . 18
Section 3.3. Optimal capital structure, risk management, bankruptcy costs and taxes. . . 19
Section 3.3.1. Does Homestake have too little debt? . . . . . . . . . . . . . . . . . . . . . 26
Section 3.4. Poorly diversified stakeholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Section 3.4.1. Risk and the incentives of managers. . . . . . . . . . . . . . . . . . . . . . . 29
Section 3.4.2. Managerial incentives and Homestake. . . . . . . . . . . . . . . . . . . . . 33
Section 3.4.3. Stakeholders. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Section 3.4.4. Are stakeholders important for Homestake? . . . . . . . . . . . . . . . . 34
Section 3.5. Risk management, financial distress and investment. . . . . . . . . . . . . . . . . . 35
Section 3.5.1. Debt overhang. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Section 3.5.2. Information asymmetries and agency costs of managerial discretion.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Section 3.5.3. The cost of external funding and Homestake. . . . . . . . . . . . . . . . 41
Section 3.6. Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Literature note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
BOX . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Figure 3.1. Cash flow to shareholders and operating cash flow. . . . . . . . . . . . . . . . . . . 49
Figure 3.2. Creating the unhedged firm out of the hedged firm. . . . . . . . . . . . . . . . . . . 50
Figure 3.3. Cash flow to shareholders and bankruptcy costs . . . . . . . . . . . . . . . . . . . . . 51
Figure 3.4. Expected bankruptcy cost as a function of volatility . . . . . . . . . . . . . . . . . . 52
Figure 3.5. Taxes and cash flow to shareholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Figure 3.6. Firm aftertax cash flow and debt issue . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Chapter 3: Creating value with risk management
December 1, 1999
Ren M. Stulz 1997, 1999
Chapter 3, page 1
Chapter objectives
1. To understand when risk management creates value for firms.
2. To show how taxes, financial distress and bankruptcy costs, contracting costs, information
asymmetries, managerial incentives, stakeholder interests, large shareholders are reasons why risk
management creates value.
3. To determine what sorts of risk have to be hedged to create value.
Chapter 3, page 2
Chapter 2 shows that a risk management program cannot increase firm value when the cost
of bearing a risk is the same whether the risk is born within or outside the firm. This result is called
the risk management irrelevance proposition. The irrelevance proposition holds when financial
markets are perfect. If the proposition holds, any risk management program undertaken by the firm
can be implemented with the same outcome by an investor through homemade risk management. The
usefulness of the risk management irrelevance proposition is that it allows us to find out when
homemade risk management is not equivalent to risk management by the firm. This is the case
whenever risk management by the firm affects firm value in a way that cannot be mimicked by
investors on their own. In this chapter, we identify situations where there is a wedge between the cost
of bearing a risk within the firm and the cost of bearing it outside the firm. Such a wedge requires the
existence of financial markets imperfections.
To show why the risk management irrelevance proposition is right, chapter 2 uses the example
of a gold producing firm. We continue using this example in this chapter. The firm is exposed to gold
price risk. The risk can be born within the firm. In this case, the firm has low income if the price of
gold is unexpectedly low and high income if it is unexpectedly high. If the irrelevance proposition
holds, the only ex ante cost of bearing this risk within the firm is that shares are worth less if gold
price risk is systematic risk because shareholders require a risk premium for gold price risk. The only
cost to the firm of having the gold price risk born outside the firm is that the firm has to pay a risk
premium to induce capital markets to take that risk. The risk premium capital markets require is the
same as the one shareholders require. Consequently, it makes no difference for firm value whether
the gold price risk is born by shareholders or by the capital markets.
The risk management irrelevance proposition makes clear that for risk management to
Chapter 3, page 3
increase firm value it has to be more expensive to take a risk within the firm than to pay capital
markets to take it. In terms of our gold producing firm example, risk management creates value if an
unexpectedly low gold price has costs for the firm that it would not have for the capital markets. An
example is a situation where, if the gold price is unexpectedly low, the firm does not have funds to
invest and hence has to give up valuable projects. For this situation to occur, it has to be that the firm
finds it costly to raise funds on capital markets if the gold price is unexpectedly low. In this case, the
unexpected low gold price implies that shareholders lose income now, but in addition they lose future
income because the firm cannot take advantage of investment opportunities. The firm does not incur
this additional cost resulting from a low gold price if the gold price risk is born by the capital markets.
To take the gold price risk, the capital markets require a risk premium. The cost of having the capital
markets take the gold price risk is less than the cost the firm has to pay if it bears the risk within the
firm. If the firm bears the risk within the firm, the cost is the risk premium required by the firms
claimholders (the shareholders in an allequity firm; the shareholders and debtholders otherwise) plus
the loss of profits due to the inability to invest optimally if the gold price is low.
In this chapter, we investigate how risk management can be used to increase firm value. We
discuss the reasons why a firm might find it more expensive to bear a risk within the firm than pay the
capital markets to bear that risk. This chapter will therefore show where the benefits of risk
management come from. More precisely, we show how risk management can decrease the present
value of bankruptcy costs and costs of financial distress, how it can decrease the present value of
taxes paid, how it can enable firms to make it more likely that they can take advantage of the positive
net present value projects available to them, and how it enables firms to provide better incentives for
managers. In the next chapter, we integrate these various sources of gain from risk management into
Chapter 3, page 4
an integrated theory of risk management.
Section 3.1. Bankruptcy costs and costs of financial distress.
In our analysis of when risk management does not create value in chapter 2, we take the
distribution of the firms cash flow before hedging, the cash flow from operations, as given. We
assume that the firm sells 100m ounces of gold at the end of the year and then liquidates. The firm
has no debt. The gold price is assumed to be normally distributed with a mean of $350 per ounce.
There are no operating costs for simplicity. All of the cash flow accrues to the firms shareholders.
This situation is represented by the straight line in figure 3.1. In that graph, we have cash flow to the
firm on the horizontal axis and cash flow to the holders of financial claims against the firm on the
vertical axis. Here, the only claimholders are the shareholders. In perfect financial markets, all cash
flows to the firm accrue to the firms claimholders, so that there is no gain from risk management.
In our analysis of chapter 2, the firm has a cash flow at the end of the year. It distributes the
cash flow to its owners, the shareholders, and liquidates. If the firm hedges, it sells its production at
the forward price so that the firms owners get the proceeds from selling the firms gold production
at the forward price. If the owners receive the proceeds from the hedged firm, they can recreate the
unhedged gold firm by taking a long forward position in gold on personal account as shown in figure
3.2. Suppose the forward price is $350. If the gold price turns out to be $450, for example, the
unhedged firm receives $350 an ounce by delivering on the forward contract while the unhedged firm
would receive $450 an ounce. An investor who owns the hedged firm and took a long forward
contract on personal account receives $350 per ounce of gold from the hedged firm plus $450  $350
per ounce from the forward contract for a total payoff of $450 per ounce which is the payoff per
Chapter 3, page 5
ounce of the unhedged firm. Hence, even though the firm is hedged, the investor can create for
himself the payoff of the unhedged firm.
Consider now the case where the firm is a levered firm. We still assume that markets are
perfect and that the distribution of the cash flow from operations is given. With our assumptions,
there are no taxes. At the end of the year, the cash flow to the firm is used to pay off the debtholders
and shareholders receive what is left over. In this case, the firms claimholders still receive all of the
firms cash flow and the firms cash flow is not changed by leverage. However, now the claimholders
are the debtholders and the shareholders. Leverage does not affect firm value because the firms cash
flow is unaffected by leverage. Hence, leverage just specifies how the pie  the firms operating cash
flow  is divided among claimants  the debtholders and the shareholders. Since the cash flow to
claimholders is the firms cash flow, risk management does not affect firm value.
Default on debt forces the firm to file for bankruptcy or to renegotiate its debt. With perfect
financial markets, claims on the firm can be renegotiated at no cost instantaneously. If financial
markets are not perfect, this creates costs for the firm. For instance, the firm might have to hire
lawyers. Costs incurred as a result of a bankruptcy filing are called bankruptcy costs. We now
assume that financial markets are imperfect because of the existence of bankruptcy costs. These costs
arise because the firm has debt that it cannot service, so that it has to file for bankruptcy.
Consequently, the value of the unlevered firm exceeds the value of the levered firm by the present
value of the bankruptcy costs. Later, we will find that there are benefits to leverage, but for the
moment we ignore them. In figure 3.3., these bankruptcy costs create a wedge between cash flow to
the firm and cash flow to the firms claimholders. This wedge corresponds to the loss of income for
the owners when the firm is bankrupt.
Chapter 3, page 6
The importance of the bankruptcy costs depends on their level and on the probability that the
firm will have to file for bankruptcy. The probability that the firm will be bankrupt is the probability
that its cash flow will be too small to repay the debt. We know how to compute such a probability
from chapter 2 for a normally distributed cash flow. Figure 3.4 shows how the distribution of cash
flow from operations affects the probability of bankruptcy. If the firm hedges its risk completely, it
reduces its volatility to zero since the claimholders receive the present value of gold sold at the
forward price. Hence, in this case, the probability of bankruptcy is zero and the present value of
bankruptcy costs is zero also. As firm volatility increases, the present value of bankruptcy costs
increases because bankruptcy becomes more likely. This means that the present value of cash flow
to the firms claimholders falls as cash flow volatility increases. Therefore, by hedging, the firm
increases firm value because it does not have to pay bankruptcy costs and hence the firms
claimholders get all of the firms cash flow. In this case, homemade risk management by the firms
claimholders is not a substitute for risk management by the firm. If the firm does not reduce its risk,
its value is lower by the present value of bankruptcy costs. Consequently, all homemade risk
management can do is eliminate the risk associated with the firm value that is net of bankruptcy costs.
Section 3.1.1. Bankruptcy costs and our present value equation.
We now use our present value equation to show that risk management increases firm value
when the only financial market imperfection is the existence of bankruptcy costs. Remember that in
the absence of bankruptcy costs, the firms claimholders receive the cash flow at the end of the year
and the firm is liquidated. With our new assumptions, the claimholders receive the cash flow if the
firm is not bankrupt. Denote this cash flow by C. If the firm is bankrupt, the claimholders receive C
Chapter 3, page 7
minus the bankruptcy costs. Consequently, the value of the firm is now:
Value of firm = PV(C  Bankruptcy costs)
We know from the previous chapter that the present value of a sum of cash flows is the sum of the
present values of the cash flows. Consequently, the value of the firm is equal to:
Value of firm = PV(C)  PV(Bankruptcy costs)
= Value of firm without bankruptcy costs  Present value of bankruptcy costs
Lets now consider the impact of risk management on firm value. If the hedge eliminates all risk, then
the firm does not incur the bankruptcy costs. Hence, the cash flow to the firms owner is what the
cash flow would be in the absence of bankruptcy costs, which is C. This means that with such a hedge
the claimholders get the present value of C rather than the present value of C minus the present value
of bankruptcy costs. Consequently, the gain from risk management is:
Gain from risk management = Value of firm hedged  Value of firm unhedged
= PV(Bankruptcy costs)
Lets look at a simple example. We assume that the interest rate is 5% and gold price risk is
unsystematic risk. The forward price is $350. Because gold price risk is unsystematic risk, the
forward price is equal to the expected gold price from our analysis of chapter 2. As before, the firm
Chapter 3, page 8
produces 1m ounces of gold. Consequently, PV(C) is equal to $350M/1.05 or $333.33M. The
present value of the hedged firm is the same (this is because E(C) is equal to 1M times the expected
gold price which is the forward price). The present value of the bankruptcy costs requires us to
specify the debt payment and the distribution of the cash flow. Lets say that the bankruptcy costs are
$20m, the face value of debt is $250m, and the volatility of the gold price is 20%. The firm is
bankrupt if the gold price falls below $250. The probability that the gold price falls below $250 is
0.077 using the approach developed in chapter 2. Consequently, the expected bankruptcy costs are
0.077*20M, or $1.54M. By the use of risk management, the firm insures that it is never bankrupt and
increases its value by the present value of $1.54M. Since gold price risk is assumed to be
unsystematic risk, we discount at the riskfree rate of 5% to get $1.47M (which is $1.54M/1.05).
In the presence of bankruptcy costs, the risk management irrelevance theorem no longer
holds. Because we assume that gold price risk is diversifiable, the cost of having the capital markets
bear this risk is zero. The risk is diversified in the capital markets and hence there is no risk premium
attached to it. In contrast, the cost of bearing the risk in the firm is $1.47M. The capital markets
therefore have a comparative advantage over the firm in bearing gold price risk. Note that if gold
price risk is systematic risk, then capital markets charge a risk premium for bearing gold price risk.
However, this risk premium is the same as the one shareholders charge in the absence of bankruptcy
costs. Hence, the capital markets still have a comparative advantage for bearing risk measured by the
bankruptcy costs saved by having the capital markets bear the risk. There is nothing that shareholders
can do on their own to avoid the impact of bankruptcy costs on firm value, so that homemade risk
management cannot eliminate these costs.
Chapter 3, page 9
Section 3.1.2. Bankruptcy costs, financial distress costs, and the costs of risk management
programs.
So far, we have described the bankruptcy costs as lawyer costs. There is more to bankruptcy
costs than lawyer costs. There are court costs and other administrative costs. An academic literature
exists that attempts to evaluate the importance of these costs. In a recent study of bankruptcy for 31
firms over the period from 1980 to 1986, Weiss (1990) finds that the average ratio of direct
bankruptcy costs to total assets is 2.8%. In his sample, the highest percentage of direct bankruptcy
costs as a function of total assets is 7%. Other studies find similar estimates of direct bankruptcy
costs. In addition, bankruptcy can have large indirect costs. For instance, management has to spend
a lot of time dealing with the firms bankruptcy proceedings instead of managing the firms
operations. Also, when the firm is in bankruptcy, management loses control of some decisions. For
instance, it might not be allowed to undertake costly new projects.
Many of the costs we have described often start taking place as soon as the firms financial
situation becomes unhealthy. Hence, they can occur even if the firm never files for bankruptcy or
never defaults. If management has to worry about default, it has to spend time dealing with the firms
financial situation. Management will have to find ways to conserve cash to pay off debtholders. In
doing so, it may have to cut investment which means the loss of future profits. Potential customers
might become reluctant to deal with the firm, leading to losses in sales. All these costs are often called
costs of financial distress. Specifically, costs of financial distress are all the costs that the firm incurs
because its financial situation has become tenuous. All our analysis of the benefit of risk management
in reducing bankruptcy costs holds for costs of financial distress also. Costs of financial distress
amount to a diversion of cash flow away from the firms claimholders and hence reduce firm value.
Chapter 3, page 10
Reducing firm risk to decrease the present value of these costs naturally increases firm value.
Reducing costs of financial distress is the most important benefit of risk management. Consequently,
we study in more detail how risk management can be used to reduce specific costs of financial distress
throughout the remainder of this chapter.
In our example, the gold mining firm eliminates all of the bankruptcy costs through risk
management. If there were costs of financial distress that occur when the firms cash flow is low, it
obviously could eliminate them as well through risk management. This is not the case in general
because there may be risks that are too expensive to reduce through risk management. We assumed
that there are no costs to reducing risk with risk management. Without risk management costs,
eliminating all bankruptcy and distress risks is optimal.
Transaction costs of risk management can be incorporated in our analysis in a straightforward
way. Suppose that there are transaction costs of taking positions in forward contracts. As transaction
costs increase, risk management becomes less attractive. If the firm bears a risk internally, it does not
pay these transaction costs. The transaction costs of risk management therefore simply increase the
cost of paying the capital markets to take the risk.
Section 3.1.3. Bankruptcy costs and Homestake.
In the previous chapter, we introduced Homestake as a gold mining firm which had a policy
of not hedging gold price exposure. As we saw, management based their policy on the belief that
Homestakes shareholders value gold price exposure. We showed that this belief is wrong because
investors can get gold price exposure without Homestake on terms at least as good as those
Homestake offers and most likely on better terms. This raises the question of whether, by not
Chapter 3, page 11
hedging, Homestakes value was lower than it would have been with hedging. Throughout this
chapter, for each source of value of hedging that we document, we investigate whether this source
of value applies to Homestake.
At the end of the 1990 fiscal year, Homestake had cash balances of more than $300 million.
In contrast, its longterm debt was $72 million and it had unused credit lines amounting to $245
million. Homestake could therefore repay all its longterm debt and still have large cash balances.
Bankruptcy is not remotely likely at that point for Homestake. However, suppose that Homestake
had a lot more longterm debt. Would bankruptcy and financial distress costs have been a serious
issue? Homestakes assets are its mines and its mining equipment. These assets do not lose value if
Homestake defaults on its debt. If it makes sense to exploit the mines, the mines will be exploited
irrespective of who owns them. It follows from this that neither bankruptcy costs nor financial distress
costs provide an important reason for Homestake to practice risk management. Though the reduction
of financial distress costs is the most important benefit of risk management in general, there are firms
for which this benefit is not important and Homestake is an example of such a firm. In the next
chapter, we will consider a type of firm that is at the opposite end of the spectrum from Homestake,
namely financial institutions. For many financial institutions, even the appearance of a possibility of
financial distress is enough to force the firm to close. For instance, in a bank, such an appearance can
lead to a bank run where depositors remove their money from the bank.
Section 3.2. Taxes and risk management.
Risk management creates value when it is more expensive to take a risk within the firm than
to pay the capital markets to bear that risk. Taxes can increase the cost of taking risks within the firm.
Chapter 3, page 12
The idea that the present value of taxes paid can be affected by moving income into future years is
wellestablished. If a dollar of taxes has to be paid, paying it later is better. Derivatives are sometimes
used to create strategies that move income to later years and we will see such uses of derivatives in
later chapters. However, in this section, we focus on how managing risk, as opposed to the timing
of income, can reduce the present value of taxes. To understand the argument, it is useful to think
about one important tax planning practice. If an individual knows that in some future year, her tax
rate will be less, that individual should try to recognize income in that year rather than in years with
a higher tax rate. Hence, given the opportunity to defer taxation on current income through a pension
plan, the investor would want to do so if the tax rate when taxes are paid is lower than the tax rate
that would apply now to the income that is deferred. With risk management, rather than altering when
income is recognized to insure that it is recognized when ones tax rate is low, one alters the risks one
takes to decrease income in a given tax year in states of the world where the tax rate is high and
increase income in the same tax year in states of the world in which the tax rate is low. By doing so,
one reduces the average tax rate one pays and hence reduces the present value of taxes paid.
To understand the role of risk management in reducing the present value of taxes, lets
consider our gold firm. Generally, firm pay taxes only if their income exceeds some level. To reflect
this, lets assume that the gold firm pays taxes at the rate of 50% if its cash flow exceeds $300M and
does not pay taxes if its cash flow is below $300M. For simplicity, we assume it is an allequity firm,
so that there are no bankruptcy costs. Figure 3.5. graphs the aftertax cash flow of the firm as a
function of the pretax cash flow. Note that now there is a difference between the firms operating
cash flow and what its shareholders receive which is due to taxes. To simplify further, we assume that
there is a 50% chance the gold price will be $250 per ounce and a 50% chance it will be $450. With
Chapter 3, page 13
this, the expected gold price is $350. Assuming that gold price risk is unsystematic risk, the forward
price for gold is $350. As before, the interest rate is 5%. In the absence of taxes, therefore, the value
of the gold mining firm is the present value of the expected cash flow, $350M discounted at 5%, or
$333.33M. Now, with taxes, the present value of the firm for its shareholders is lower since the firm
pays taxes when the gold price is $450. In this case, the firm pays taxes of 0.5*(450300)*1M, or
$75M. With taxes, the value of the firms equity is:
Value of firm with taxes = PV(Gold sales  Taxes)
= PV(Gold sales)  PV(Taxes)
= PV(Firm without taxes)  PV(Taxes)
= $333.33m  $35.71M
= $297.62M.
Lets figure out the cost to shareholders of having the firm bear gold price risk. To do that,
we have to compare firm value if the gold price is random with firm value if the gold price has no
volatility and is fixed at its expected value. Remember that the gold price can be either $250 or $450.
If the gold price is $250, the shareholders get $250 per ounce. Alternatively, if the gold price is $450,
they get $375 per ounce ($450 minus taxes at the rate of 50% on $150). The expected cash flow to
the shareholders is therefore 0.5*250 + 0.5*375 or $312.5 per ounce, which is $12.50 less than $325.
In this case, expected taxes are $37.5 per ounce. If the gold price is fixed at its expected value instead
so that cash flow is not volatile, shareholders receive $325 per ounce since they must pay taxes at the
rate of 50% on $50. In this case, expected taxes are $25 per ounce. Taking present values, the equity
Chapter 3, page 14
value is $309.52 per ounce in the absence of cash flow volatility and $297.62 if cash flow is volatile.
Hence, the cost to the shareholders of having the firm bear the gold price risk is $11.90 per ounce
or $11.90M for the firm as a whole.
Lets look at the cost of having the capital markets bear the gold price risk. If gold price risk
is unsystematic risk, there is no risk premium. The capital markets charge a cost for bearing gold price
risk with our assumptions only if taxes affect the pricing of risky assets. Tax status differs across
investors. For instance, some investors pay no taxes because they are institutional investors; other
investors pay taxes as individuals in the top tax bracket. Lets suppose that capital markets are
dominated by investors who pay no taxes and that therefore securities are priced ignoring taxes. In
this case, the CAPM applies to pretax returns and the cost of bearing gold price risk for the capital
markets is zero. Hence, the capital markets have a comparative advantage in bearing gold price risk.
If the firm has the capital markets bear gold price risk, it sells gold forward and gets $350m.
Shareholders get less because the firm has to pay taxes. They get $325m or $309.52m in present
value. This is the value of the firm if gold is not random. Hence, capital markets charge nothing for
bearing the risk, but if the firm bears the risk itself, the cost to the firm is $11.90m.
The reason the firm saves taxes through risk management is straightforward. If the firms
income is low, the firm pays no taxes. In contrast, if the firms income is high, it pays taxes. Shifting
a dollar from when the income is high to when the income is low saves the taxes that would be paid
on that dollar when the income is high. In our example, shifting income of a dollar from when income
is high to when income is low saves $0.50 with probability 0.5.
It should be clear why homemade risk management cannot work in this case. If the firm does
not use risk management to eliminate its cash flow volatility, its expected taxes are higher by $12.5M.
Chapter 3, page 15
This is money that leaves the firm and does not accrue to shareholders. If the firm does not hedge,
shareholders can eliminate the risk from holding the shares. However, through homemade risk
management, shareholders can only guarantee an expected payoff of $312.5M. Lets figure out how
shareholders would practice homemade risk management. Note that there are only two possible
outcomes: $375 per share or $250 per share with equal probability. Hence, shareholders must take
a forward position per ounce that insures a payoff of $312.5. Let h be the short forward position per
ounce. We then need:
Gold price is $250: $250  h(350  250) = 312.5
Gold price is $450: $375  h(350  450) = 312.5
Solving for h, we get h to be equal to 0.6125. Hence, the investor must sell short 0.6125 ounces to
insure receipt of $312.5 per ounce at the end of the year. If the gold price is $250 an ounce, the
shareholders get $250 per share from the firm and 0.6125*(350  250), or $75, from the forward
position. This amounts to $325. The investor is unambiguously better off if the firm hedges directly.
The marginal investor is the one that would not invest in an asset if its expected return was
slightly less. If gold price risk is diversifiable for this investor, this means that the investor does not
expect to make a profit from taking gold price risk net of taxes. So far, we assumed that the marginal
investor pays no taxes. Suppose that, instead, the marginal investor has a positive tax rate. It turns
out that making this different assumption does not change our analysis as long as the marginal
investors tax rate is not too different when the gold price is high and when it is low. Since gold price
risk is diversifiable, one would not expect an unexpectedly high or low gold price to change the
Chapter 3, page 16
marginal investors tax bracket. Lets see that this works. Suppose that the tax rate of the marginal
investor is 40% and that this tax rate is the same for the high and the low gold price. Remember that,
since the gold price risk is unsystematic risk for the marginal investor, the investors aftertax
expected profit from a forward contract should be zero. In this case, if the investor takes a long
forward position, she expects to receive after tax:
0.5*(10.4)*(450  F) + 0.5*(10.4)*(250  F) = 0
The forward price that makes the expected payoff of a long forward position equal to zero is $350
in this case. Hence, the tax rate does not affect the forward price. This means that when the marginal
investor has a constant positive tax rate, the capital markets still charge nothing to bear unsystematic
gold price risk.
Section 3.2.1. The tax argument for risk management.
The tax argument for risk management is straightforward: By taking a dollar away from a
possible outcome (often called a state of the world in finance) in which it incurs a high tax rate and
shifting it to a possible outcome where it incurs a low tax rate, the taxpayer  a firm or an investor 
reduce the present value of taxes to be paid. The tax rationale for risk management is one that is
extremely broadbased: it applies whenever income is taxed differently at different levels. The tax
code introduces complications in the analysis. Some of these complications decrease the value of
hedging, whereas others increase it. Here are some of these complications:
1. Carrybacks and carryforwards. If a firm has negative taxable income, it can offset
Chapter 3, page 17
future or past taxable income with a loss this tax year. There are limitations to the ability to carry
losses back or forward. One set of limitations is that losses can be carried back or forward only for
a limited number of years. In addition, no allowance is made for the timevalue of money. To see the
importance of the timevalue of money, consider a firm which makes a gain of $100,000 this year and
a loss of $100,000 in three years. It has no other income. The tax rate is 30%. Three years from now,
the firm can offset the $100,000 gain of this year with the loss. However, it must pay $30,000 in taxes
this year and only gets back $30,000 in three years, so that it loses the use of the money for three
years.
2. Tax shields. Firms have a wide variety of tax shields. One of these tax shields is the tax
shield on interest paid. Another is the tax shield on depreciation. Firms also have tax credits. As a
result of the complexity of the tax code, the marginal tax rate of firms can be quite variable. Further,
tax laws change so that at various times firms and investors know that taxes will increase or fall. In
such cases, the optimal risk management program is one that increases cash flows when taxes are low
and decreases them when they are high.
3. Personal taxes. In our discussion, we assumed that the tax rate of the marginal investor
on capital markets is uncorrelated with firm cash flow. Even if this is not the case, a general result
holds: As long as the tax rate of investors differs from the tax rate of the corporation, it pays for the
corporation to reallocate cash flow from possible outcomes where the combined tax rate of investors
and the corporation is high to other possible outcomes where it is low.
It is difficult to incorporate all these real life complications in an analytical model to evaluate the
importance of the tax benefits of risk management. To cope with this problem, Graham and Smith
Chapter 3, page 18
(1999) use a simulation approach instead. Their paper does not take into account personal taxes, but
otherwise it incorporates all the relevant features of the tax code. They simulate a firms income and
then evaluate the tax benefit of hedging. They find that for about half the firms, there is a tax benefit
from hedging, and for these firms the typical benefit is such that a 1% decrease in the volatility of
taxable income for a given year decreases the present value of taxes by 1%.
Section 3.2.2. The tax benefits of risk management and Homestake
In 1990, Homestake paid taxes of $5.827 million dollars. It made a loss on continuing
operations because it wrote down its investment in North American Metals Corporation. Taxation
in extracting industries is noticeably complicated and hence makes it difficult to understand the extent
to which Homestake could reduce the present value of its taxes with risk management. However, the
annual report is useful in showing why the tax rate of Homestake differs from the statutory tax rate
of 34%. In thousand dollars, the taxes of Homestake differ from the statutory tax as follows:
Homestake made a loss of 13,500. 34% of that loss would yield taxes of (4,600)
Depletion allowance (8,398)
State income taxes, net of Federal benefit (224)
Nondeductible foreign losses 18,191
Othernet 858
Total $ 5,827
It is striking that Homestake paid taxes even though it lost money. The exact details of the
nondeductible foreign losses are not available from the annual report. It seems, however, that part
Chapter 3, page 19
of the problem is due to a nonrecurring writedown which may well have been unpredictable.
Although risk management to smooth taxes is valuable, it is unlikely that Homestake could have
devised a risk management program that would have offset this writedown with foreign taxable
gains. At the same time, variations in the price of gold could easily lead to a situation where
Homestake would make losses. Avoiding these losses would smooth out taxes over time and hence
would increase firm value. Based on the information in the annual report, we cannot quantify this
benefit. Petersen and Thiagarajan (1998) compare American Barrick and Homestake in great detail.
In their paper, they find that Homestake has a tendency to time the recognition of expenses when gold
prices are high to smooth income, which may decrease the value of using derivatives to smooth
income.
Section 3.3. Optimal capital structure, risk management, bankruptcy costs and taxes.
Generally, interest paid is deductible from income. A levered firm therefore pays less in taxes
than an unlevered firm for the same operating cash flow. This tax benefit of debt increases the value
of the levered firm relative to the value of the unlevered firm. If a firms pretax income is random,
however, there will be circumstances where it cannot take full advantage of the tax benefit of debt
because its operating cash flow is too low. Hence, decreasing the volatility of cash flow can increase
firm value by making it less likely that the operating cash flow is too low to enable the firm to take
advantage of the tax shield of debt.
Lets consider the impact on the tax shield from debt of a risk management program that
eliminates cash flow volatility. We use the same example as we did in the previous section, in that the
firm pays taxes if its cash flow exceeds $300M. However, now the firm issues debt and pays out the
Chapter 3, page 20
proceeds of debt to the shareholders. Suppose that the shareholders decide to issue debt with face
value of $200M. Since the risk of the firm is diversifiable, the debtholders expect to receive a return
of 5%. Since the firm is never bankrupt with an interest rate of 5%, the debt interest payment will be
5% of $200M, or $10M. At the end of the year, the firm has to make a debt payment of $210M. If
the firms cash flow at the end of the year is $250M because the gold price is $250 an ounce, the firm
pays no taxes. Hence, it does not get a tax benefit from having to pay $10M in interest. In contrast,
if the firms cash flow is $450M, the firm gets to offset $10M against taxable income of $150M and
hence pays taxes only on $140M. This means that the value of the firm is:
Value of levered firm = PV(Cash flow  taxes paid)
= PV(Cash flow)  PV(Taxes paid)
= 333.33M  0.5*0.5*(450M  300M  10M)/1.05
= 333.33M  33.33M
= 300M
The value of the firm is higher than in the previous section because the firm benefits from a tax shield
of $10m if the gold price is $450 per ounce. The expected value of that tax shield is 0.5*0.5*10M,
or $2.50M. The present value of that amount is $2.38M using the riskfree rate of 5% as the discount
rate since gold price risk is unsystematic risk. In the previous section, the value of the firm in the
absence of risk management was $297.62M, which is exactly $2.38M less than it is now. The
difference between $300M and $297.62M represents the benefit of the tax shield of debt. However,
when the cash flow is risky, the firm gets the benefit only when the price of gold is $450 an ounce.
1
If the funds were kept within the firm, they would have to be invested which would
complicate the analysis because taxes would have to be paid on the investment income.
Chapter 3, page 21
Consider the situation where the firm eliminates the volatility of cash flow. We know that in
this case the firm insures a cash flow pretax of $350M. Its taxable income with debt is $350M 
$10M  $300M, or $40M, so that it pays taxes of $20M for sure. Firm value is therefore the present
value of $350M  $20M, or $314.286M. In the absence of debt, hedged firm value is instead
$309.524M. Shareholders therefore gain $4.762M by issuing debt and hedging. The benefit from
hedging in this example comes solely from the increase in the tax shield of debt. Since the firm issues
riskfree debt, the interest rate on the debt does not depend on whether the firm hedges or not in our
example.
In our analysis so far, we took the firms debt as given. With a promised payment to
debtholders of $210M, the firm is never bankrupt yet benefits from the tax shield of debt. Lets now
extend the analysis so that the tax shield of debt is maximized. If this involves increasing the firms
debt, we assume that the funds raised are paid out to shareholders in the form of a dividend so that
the firms investment policy is unaffected.
1
Lets start with the case where the firm eliminates gold
price risk and can guarantee to the debtholders that it will do so. Since in that case the firm has no
risk, it either never defaults or always defaults. One would expect the IRS to disallow a deduction
for debt that always defaults, so that the total debt and tax payments cannot exceed $350M for the
firm to benefit from a tax shield of debt. Since the firm never defaults with hedging, it can sell the new
debt so that it earns the riskfree rate of 5% since it is riskfree. To maximize firm value, we maximize
the expected cash flow minus taxes paid:
Chapter 3, page 22
Firm cash flow = 350M  0.5Max(50M  0.05F,0)
where F is the amount borrowed. Since the firm has no volatility, it is never bankrupt. Figure 3.6.
plots firm value imposing the constraint that total debt and tax payments cannot exceed $350M. Since
the tax shield increases with debt payments, the firm wants to issue as much debt as it can without
being bankrupt. This means that taxes plus debt payments have to equal $350M. Solving for F, we
get $317.073M. To see that this works, note that the firm has to pay taxes on 50M  10M 
0.05*117.073M, corresponding to taxes of $17.073M. The debt payments amount to $210M plus
1.05*$117.073, or $332.927M. The sum of debt payments and taxes is therefore exactly $350M. The
shareholders get nothing at maturity, so that the firm is an alldebt firm after the additional debt issue
(one could always have the shareholders hold a small amount of equity so that the firm is not an all
debt firm). They benefit from the increase in leverage because they receive a dividend worth
$317.073M when the debt is issued. If the firm issues only debt with principal of $200M, the
shareholders own a firm worth $314.286M in the form of a dividend of $200M and shares worth
$114.286. Hence, by issuing more debt, shareholders increased their wealth by a further $2.787M.
To check that the shareholders have chosen the right amount of debt, lets see what happens
if they issue an additional $1M of debt that they pay out as a dividend. This would lead to an
additional debt payment of $1.05M. Taxes would fall by $0.025M because of the addition $0.05M
of interest payment, so that the firm would have to pay net an additional $1.025M. As a result of this
additional promised payment, the firm would always bankrupt. Suppose next that the firm issues $1M
less of debt. In this case, the dividend falls by $1M and the firm has $1.05M less of debt payments
at the end of the year. This has the effect of increasing taxes by $0.025M, so that shareholders get
05 230 05 1 . * . ( ) + +
=
x F
1.05
F
450  0.5(150  xF)  (1+ x)F = 0
2
Let x be the promised interest rate on debt and F be the amount borrowed in millions. To
solve for x and F, we have to solve two equations:
The first equation states that the present value of the debt payoffs has to be equal to the principal.
The second equation states that the cash flow if the gold price is $450 an ounce has to be equal to
the debt payment and taxes.
Chapter 3, page 23
$1.025M at the end of the year. The present value of $1.025M is less than $1M, so that shareholder
equity falls as a results of decreasing debt.
Suppose now that the firm wants to maximize its value without using risk management. In this
case, if the optimum amount of debt is such that the debt payment exceeds $250M, the firm is
bankrupt with probability 0.5. Since, in this case, increasing the principal amount of debt further does
not affect bankruptcy costs, the firms best strategy would be to issue a sufficient amount of debt so
that it minimizes taxes paid when the gold price is $450 an ounce since it pays no taxes when the gold
price is $250 an ounce. Consequently, the firm chooses debt so that the debt payment plus taxes paid
are equal to the beforetax cash flow of $450M. If the firm does that, it will be bankrupt if the gold
price is $250 an ounce. If bankruptcy takes place, the firm incurs a bankruptcy cost which we assume
to be $20M as before so that bondholders get $230M in that case. Since the firm defaults when the
gold price is $250 an ounce, the yield of the debt has to exceed the riskfree rate so that the expected
return of the bondholders is the riskfree rate. The bondholders require an expected return equal to
the riskfree rate because we assumed that gold price risk is nonsystematic risk. Solving for the
promised interest rate and the amount borrowed, we find that the firm borrows a total amount of
316.29M promising to pay interest at the rate of 37.25%.
2
The value of the firm to its shareholders
Chapter 3, page 24
corresponds to the amount borrowed of 316.29M, so that the value of the firm is lower in the absence
of risk management.
The difference between firm value with risk management and firm value without risk
management depends crucially on the bankruptcy cost. As the bankruptcy cost increases, the risk
management solution becomes more advantageous. If the bankruptcy cost is $100M, the value of the
firm without risk management falls to $290.323. In this case, the firm has a higher value with no debt.
If there is no bankruptcy cost, the solution that involves no risk management has higher value than
the solution with risk management because it eliminates more taxes when the firm is profitable. In this
case, firm value is $322.581M. The problem with the solution without risk management is that it may
well not be possible to implement it: It involves the firm going bankrupt half the time in this example,
so that the IRS would probably disallow the deduction of the interest payment from taxable income,
viewing the debt as disguised equity.
It is important to note that if the firm engages in risk management but debtholders do not
believe that it will do so, then the debt is sold at a price that reflects the absence of risk management.
In this case, the yield on debt where there is a probability of default is higher to reflect the losses
bondholders make if the firm defaults. If shareholders are paying the bondholders for the risk of
bankruptcy, it may not make sense to remove that risk through risk management because doing so
might benefit mostly bondholders. If the firm issues debt so that there is no significant risk of
bankruptcy, it matters little whether bondholders believe that the firm will hedge or not. However,
many firms could increase their leverage without significantly affecting their probability of
bankruptcy. For such firms, risk management would be valuable because it implies that firms capture
Chapter 3, page 25
more of the tax shield of debt.
In the example discussed here, firm value depends on leverage because of the existence of
corporate taxes. If there is a tax shield of debt, more leverage decreases taxes to be paid. However,
with bankruptcy costs, there is an offsetting effect to the tax benefit of debt. As leverage increases,
it becomes more likely that the firm will be bankrupt and hence that bankruptcy costs will have to be
paid. This reasoning leads to an optimal capital structure for a firm. Without bankruptcy costs but a
tax shield of debt, the optimal capital structure would be for the firm to be all debt since this would
maximize the tax shield of debt. With bankruptcy costs but without a tax shield of debt, the firm
would not want any debt since there is no benefit to debt but only a cost. With bankruptcy costs and
with a tax shield of debt, the firm chooses its capital structure so that the tax benefit of an additional
dollar of debt equals the increase in bankruptcy costs. When bankruptcy costs are nontrivial, the firm
finds it worthwhile to decrease risk through risk management so that it can increase leverage. In
general, the firm cannot eliminate all risk through risk management so that there is still some
possibility of bankruptcy. As a result, the optimal solution is generally far from having only debt.
Further, as we will see later, there are other reasons for firms not to have too much debt.
All our tax discussion has taken place assuming a very simple tax code. One complication we
have ignored is that investors pay taxes too. Miller (1978) has emphasized that this complication can
change the analysis. Suppose investors pay taxes on coupon income but not on capital gains. In this
case, the required expected return on debt will be higher than on equity to account for the fact that
debt is taxed more highly than equity at the investor level. In this case, the tax benefit at the
corporation level of debt could be decreased because of the higher yield of debt. At this point,
though, the consensus among financial economists is that personal taxes limit the corporate benefits
Chapter 3, page 26
from debt but do not eliminate them. In any case, if the firm has tax shields, whether there are
personal taxes or not, the corporation will want to maximize their value.
Section 3.3.1. Does Homestake have too little debt?
The answer to this question is undoubtedly yes. Homestake is paying taxes every year. Most
years, its tax rate is close to the statutory rate of 34%. In 1990, as we saw, Homestake pays taxes at
a rate that even exceeds the statutory rate. Yet, we also saw that Homestake has almost no debt and
that its longterm debt is dwarfed by its cash balances. By increasing its debt, Homestake would
increase its tax shield of debt and reduce its taxes. Doing so, however, it would increase the
importance of risk management to avoid wasting the tax shield of debt when the price of gold moves
unfavorably.
Section 3.4. Poorly diversified stakeholders.
So far, we assumed that risk management involves no transaction costs. Suppose, however,
that homemade risk management is more expensive than risk management by the firm. In this case,
investors might care about the risks that the firm bears. However, investors who own large diversified
portfolios are relatively unaffected by the choices of an individual firm. On average, the risks balance
out except for systematic risks that have to be born by the economy as a whole and can easily be
controlled by an investor through her asset allocation. There are, however, investors for whom these
risks do not balance out because they have a large position in a firm relative to their wealth. These
investors might be large investors who value a control position. They might also be management who
has a large stake in the firm for control reasons or because of a compensation plan. Investors who
Chapter 3, page 27
cannot diversify away firmspecific risk want the firm to decrease it unless they can reduce risk more
cheaply through homemade risk management.
Consider the case of our gold producing firm. Now, this firm has one big shareholder whose
only investment is her holding of 10% of the shares of the firm. The shareholder is not diversified and
consequently cares about the diversifiable risk of the gold mining firm. Unless she strongly expects
the price of gold to be high at the end of the year, she wants to reduce the risk of her investment. To
do that, she could sell her stake and invest in a diversified portfolio and the riskfree asset. Second,
she could keep her stake but use homemade hedging. Third, she could try to convince the firm to
hedge.
Lets assume that the investor wants to keep her stake intact. There are circumstances such
that the investor might prefer the firm to hedge instead of having to do it herself. This will be the case
when there are large setup costs for trading in financial instruments used to hedge and the firm has
already paid these costs. For instance, suppose that a banking relationship is required to set up the
appropriate hedge. The firm has such a relationship and the investor does not. In such a situation, the
investor would want the firm to hedge because homemade hedging is not possible. It is therefore
possible for the firm to have a comparative advantage in hedging. It is not clear, though, why the firm
would expend resources to hedge to please that large investor. If the only benefit of hedging is that
this large investor does not have to hedge on her own, the firm uses resources to hedge without
increasing firm value. If the large shareholder cannot hedge and sells her shares, she is likely to be
replaced by welldiversified shareholders who would not want the firm to pay to hedge and thereby
decrease its value. There is no clear benefit for the firm from having the large shareholder in our
example. If the firm gains from having the large shareholder, then it can make sense to hedge to make
Chapter 3, page 28
it possible for the large shareholder to keep her investment in the firm.
Having large shareholders can increase firm value. Small, highly diversified, shareholders have
little reason to pay much attention to what the firm is doing. Such shareholders hold the market
portfolio and cannot acquire easily information that allows them to beat the market. Evaluating the
actions of management takes time. Suppose that by spending one month of her time a shareholder has
a 10% chance of finding a way to increase the value of a firm by 5% and that, if this happens,
spending a month to convince management has a 20% chance of success. With these odds, a
shareholder whose time is worth $10,000 a month would need an investment in the firm of at least
$500,000 to justify starting the process of studying the firm. One might argue about the odds we give
the shareholder of finding something useful and of convincing management that she did. Most likely,
however, the true odds are much worse for the shareholder. Further, most diversified shareholders
have a smaller stake in a firm than $500,000. Hence, most diversified shareholders get no benefit
from evaluating carefully the actions of managers. A shareholder who has a stake of $10M in a firm
will follow the actions of management carefully even if the odds against her finding something that
would increase the value of the firm are worse than we assumed. The action of evaluating
management and trying to improve what it does is called monitoring management. Large
shareholders get greater financial benefits from monitoring management than small ones.
There are two reasons why monitoring by shareholders can increase firm value. First, an
investor might become a large shareholder because she has some ability in evaluating the actions of
management in a particular firm. Such an investor has knowledge and skills that are valuable to the
firm. If management chooses to maximize firm value, management welcomes such an investor and
listens to her carefully. Second, management does not necessarily maximize firm value. Managers
Chapter 3, page 29
maximize their welfare like all economic agents. Doing so sometimes involves maximizing firm value,
but other times it does not. What a manager does depends on his incentives. A manager whose only
income is a fixed salary from the firm wants to make sure that the firm can pay his salary. If an action
increases firm value but has much risk, that manager may decide against it because a firm that is
bankrupt cannot pay his salary. A large shareholder can make it more likely that management
maximizes firm value by monitoring management. For instance, a large shareholder might find that
management failed to take an action that maximizes firm value and might draw the attention of other
shareholders to her discovery. In some cases, a large shareholder might even convince another firm
to try to make a takeover attempt to remove management and take actions that maximize firm value.
A firms risk generally makes it unattractive for a shareholder to have a stake large enough that it is
worthwhile for him to monitor a firm. By hedging, a firm can make it more attractive for a
shareholder that has some advantage in monitoring management to take a large stake. As the large
shareholder takes such a stake, all other shareholders benefit from his monitoring.
Section 3.4.1. Risk and the incentives of managers.
Since managers, like all other individuals associated with the firm, pursue their own interests,
it is important for shareholders to find ways to insure that managers interests are to maximize the
value of the shares. One device at the disposal of shareholders for this purpose is the managerial
compensation contract. By choosing a managerial contract which gives managers a stake in how well
the firm does, shareholders help insure that managers are made better off by making shareholders
richer. If managers earn more when the firm does better, this induces them to work harder since they
benefit more directly from their work. However, managerial compensation related to the stock price
Chapter 3, page 30
has adverse implications for managers also. It forces them to bear risks that have nothing to do with
their performance. For instance, a firm may have large stocks of raw materials that are required for
production. In the absence of a risk management program, the value of these raw materials fluctuates
over time. Random changes in the value of raw materials may be the main contributors to the
volatility of a firms stock price, yet management has no impact on the price of raw materials. Making
managerial compensation depend strongly on the stock price in this case forces management to bear
risks, but provides no incentive effects and does not align managements incentives with those of
shareholders. In fact, making managerial compensation depend strongly on the part of the stock
return which is not under control of management could be counterproductive. For instance, if the
value of raw materials in stock strongly affects the riskiness of managerial compensation, managers
might be tempted to have too little raw materials in stock.
If it is easy to know how variables that managers do not control affect firm value, then it
would be possible to have a management compensation contract that depends only on the part of the
stock return that is directly affected by managerial effort. Generally, however, it will be difficult for
outsiders to find out exactly which variables affect firm value. Hence, in general it will make sense
to tie managerial compensation to some measure of value created without trying to figure out what
was and what was not under managements control. Management knows what is under its control.
It could reduce risk through homemade hedging, but it might be more cost effective to have the firm
hedge rather than having managers trying to do it on their own. If the firm can reduce its risk through
hedging, firm value depends on variables that management controls, so that having compensation
closely related to firm value does not force management to bear too much risk and does not induce
management to take decisions that are not in the interest of shareholders to eliminate this risk. This
Chapter 3, page 31
makes it possible to have managerial compensation closely tied to firm value, which means that when
managers work hard to increase their compensation, they also work hard to increase shareholder
wealth.
Having management own shares in the firm they manage ties their welfare more closely to the
welfare of the shareholders. Again, if management owns shares, they bear risk. Since managers are
not diversified shareholders, they care about the firms total risk. This may lead them to be
conservative in their actions. If the firm reduces risk through risk management, the total risk of the
firm falls. Consequently, managers become more willing to take risks. This means that firmwide
hedging makes managerial stock ownership a more effective device to induce management to
maximize firm value.
Another argument can be made to let management implement a risk management program
within the firm. Suppose that instead of having compensation depend directly on firm value, it
depends on firm value indirectly in the sense that managements employment opportunities depend
on the performance of the firm s stock. In this case, in the absence of firmmade risk management,
firm value fluctuates for reasons unrelated to managerial performance. As a result, the markets
perception of managers can fall even when managers perform well. This is a risk that managers cannot
diversify. Having a risk management program eliminates sources of fluctuation of the firms market
value that are due to forces that are not under control of management. This reduces the risk attached
to managements human capital. Again, management is willing to have a lower expected
compensation if the risk attached to its human capital is lower. Hence, allowing management to have
a risk management program has a benefit in the form of expected compensation saved which increases
firm value. Possibly the greater benefit from allowing management to have a risk management
Chapter 3, page 32
program is that this makes it less likely that management undertakes risk reducing activities that
decrease firm value but also decrease the risks that management bears.
Not every form of compensation that depends on firm value induces management to try to
reduce firm risk. Suppose that management receives a large payment if firm value exceeds some
threshold. For instance, in our gold producing firm, suppose that management receives a $20m bonus
if firm value before management compensation exceeds $400m at the end of the year. In this case,
management receives no bonus if the firm hedges and has a 50% chance of getting a bonus if the firm
does not hedge. Obviously, management will not hedge. Management compensation contracts of this
types make managements compensation a nonlinear function of firm value. If management owns call
options on the firms stock, it has incentives to take risks. Call options pay off only when the stock
price exceeds the exercise price. They pay more for large gains in the stock price. An option pays
nothing if the stock price is below the exercise price, no matter how low the stock price is. Hence,
managerial compensation in the form of options encourages management to take risks so that the
stock price increases sufficiently for the options to have value. In fact, managements incentives might
be to take more risk than is required to maximize firm value.
To see how options might induce management to not hedge when hedging would maximize
firm value, lets consider our gold firm example. Suppose that management owns a call option on
1,000 shares with exercise price of $350 a share. For simplicity, lets assume that management
received these options in the past and that exercise of the options does not affect firm value. In our
gold firm example, suppose that there is a tax advantage to hedging as discussed in section 2. In this
case, firm value before managerial compensation is maximized if the firm hedges. Hedging locks in
a firm value before managerial compensation of $309.52. In this case, the options management has
Chapter 3, page 33
are worthless. If the firm does not hedge, there is a 50% chance that the shares will be worth $375
and hence a 50% chance that the options will pay off.
Section 3.4.2. Managerial incentives and Homestake.
The Homestake proxy statement for 1990 shows that the directors own 1.1% of the shares.
As mentioned earlier, two of the directors are executives of a company which owns 8.2% of
Homestake. The CEO of Homestake, Mr. Harry Conger, owns 137,004 shares directly and has the
right to acquire 243,542 shares through an option plan. The shares in the option plan have an average
exercise price of $14.43, but the share price in 1990 has a high of 23.6 and a low of 15.3.
Management holds few shares directly and much less than is typical for a firm of that size. Most of
managements ownership is in the form of options. There is not much incentive for management to
protect its stake in the firm through hedging and management might benefit some from volatility
through its option holdings.
Section 3.4.3. Stakeholders.
So far in this section, we have considered individuals  large shareholders and managers  for
whom it was costly to be exposed to firm risk. We saw that the firm could benefit by reducing the
firm risk that these individuals are exposed to. The reason these individuals were exposed to firm risk
was that they could not diversify this risk away in their portfolio or use homemade hedging
effectively. There are other individuals associated with corporations that are in a similar situation. All
individuals or firms whose welfare depends on how well the firm is doing and who cannot diversify
the impact of firm risks on their welfare are in that situation. Such individuals and firms are often
Chapter 3, page 34
called stakeholders. It can be advantageous for a firm to reduce the risks that its stakeholders bear.
Often, it is important for the firm to have its stakeholders make longterm firmspecific investments.
For instance, the firm might want workers to learn skills that are worthless outside the firm. Another
example might be a situation where a firm wants a supplier to devote R&D to design parts that only
that firm will use. A final example is one where customers have to buy a product whose value
depends strongly on a warranty issued by the firm. In all these cases, the stakeholders will be reluctant
to make the investments if they doubt that the firm will be financially healthy. If the firm gets in
financial trouble, it may not be able to live up to its part of the bargain with the stakeholders. This
bargain is that the stakeholders invest in exchange for benefits from the firm over the longterm.
Hedging makes it easier for the firm to honor its bargain with the stakeholders.
If the firm does not reduce its risk, it may only be able to get the stakeholders to make the
requisite investments by bribing them to do so. This would mean paying workers more so that they
will learn the requisite skills, paying the suppliers directly to invest in R&D, and selling the products
more cheaply to compensate for the risks associated with the warranty. Such economic incentives can
be extremely costly. If hedging has low costs, it obviously makes more economic sense for the firm
to hedge rather than to use monetary incentives with its stakeholders.
Section 3.4.4. Are stakeholders important for Homestake?
No. The firm is financially healthy so that there is no risk of bankruptcy. The firm could suffer
large losses before bankruptcy would become an issue. Hence, those having relationships with the
firm have no good reason to worry about getting paid.
Homestake has one large shareholder, Case, Pomeroy and Co. This company owns 8.1% of
Chapter 3, page 35
the shares. Two executives of that company are represented on the board of directors. Case has been
decreasing its stake in Homestake and has a standstill agreement with Homestake that prevents it
from buying more shares and gives Homestake rights of first refusal when Case sells shares. This
large shareholder can hedge on its own if it chooses to do so.
Section 3.5. Risk management, financial distress and investment.
So far, we have paid little attention to the fact that firms have opportunities to invest in
valuable projects. For instance, suppose that the gold firm we focused on does not liquidate next
period but instead keeps producing gold. Now, this firm has an opportunity to open a new mine a
year from now. This mine will be profitable, but to open it a large investment has to be made. If the
firm does not have sufficient internal resources, it has to borrow or sell equity to finance the opening
of the mine. There are circumstances where a firms lack of internal resources makes it impossible
for the firm to take advantage of projects that it would invest in if it had more internal resources
because the costs of external financing are too high. In other words, it could be that the gold mining
firm in our example might not be able to open the mine because of a lack of internal resources. In this
case, the shareholders would lose the profits that would have accrued to them if the mine had been
opened. Firm value would have been higher had the firm managed its affairs so that it would not have
gotten itself into a situation where it cannot invest in profitable projects. In the remainder of this
section, we investigate the main reasons why firms might not be able to invest in profitable projects
and show how risk management can help firms avoid such situations.
Chapter 3, page 36
Section 3.5.1. Debt overhang.
Consider a firm with debt obligations that are sufficiently high that if the firm had to pay off
the debt today it could not do so and normal growth will not allow it to do so when the debt matures.
Such a situation creates a conflict between the firms creditors and the firms shareholders.
Shareholders want to maximize the value of their shares, but doing so can be inconsistent with
maximizing firm value and can reduce the value of the firms debt. First, shareholders may want to
take risks that are not beneficial to the firm as a whole. Second, they may be unwilling to raise funds
to invest in valuable projects. We look at these problems in turn.
We assumed that the firm cannot pay off its debt today. If the firm does not receive good
news, when the debt has to be paid off, shareholders will receive nothing and the creditors will own
the firm. Consequently, shareholders want to make it more likely that the firm will receive good news.
To see the difficulty this creates, consider the extreme case where the firm has no risk with its current
investment policies. In this case, unless shareholders do something, their equity is worthless. Suppose
however that they liquidate existing investments and go to Las Vegas with the cash they have
generated. They bet the firm at a game of chance. If they lose, the cash is gone. The loss is the
creditors loss since equityholders were not going to get anything anyway. If they win, the firm can
pay off the creditors and something is left for the equityholders. This strategy has a positive expected
profit for the shareholders so they want to undertake it  if they can. In contrast, this strategy has a
negative expected profit for the firm. This is because betting in Las Vegas is not a fair gamble  the
house has to make money on average. Excess leverage resulting from adverse shocks to firm value
therefore leads shareholders to do things that hurt firm value but help them. The possibility that there
is some chance that the firm might be in such a situation therefore reduces its value today. If low cost
Chapter 3, page 37
risk management can decrease the probability that the firm might ever find itself in such a situation,
it necessarily increases firm value. Unfortunately, if the firm reduces risk through risk management
but nevertheless finds itself in a situation where shareholders believe that gambling would benefit
them, they may choose to give up on risk management. Since they would give up on risk management
precisely when bondholders would value it the most  because any loss is a loss for the bondholders
 this possibility can make it harder to convince bondholders that the firm will consistently reduce
risk.
Consider again a firm with large amounts of debt that it could not repay if it had to do so
today. In contrast to the previous paragraph, we now assume that the firm cannot sell its assets. This
could be because bond covenants prohibit it from doing so or because the market for the firms assets
is too illiquid. Now, suppose that this firm has an investment opportunity. By investing $10m., the
firm acquires a project that has a positive net present value of $5m. This project is small enough that
the firm still could not repay its debt if it took the project and had to repay the debt today. The firm
does not have the cash. The only way it can invest is by raising funds. In this situation, shareholders
may choose not to raise the funds.
In our scenario, the firm could raise funds in two ways: It could borrow or issue equity. Since
the firm cannot repay its existing debt in its current circumstances, it cannot raise debt. Any debt
raised would be junior to the existing debt and would not be repaid unless the value of the firm
increases unexpectedly. Consequently, the firm would have to sell equity. Consider the impact of
having an investor invest one dollar in a new share. Since the firm is expected to default, that dollar
will most likely end up in the pockets of the creditors. If something good happens to the firm so that
equity has value, there will be more shareholders and the existing shareholders will have to share the
Chapter 3, page 38
payoff to equity with the new shareholders. This is most likely a nowin situation for the existing
shareholders: They do not benefit from the new equity if the firm is in default but have to share with
the new equity if the firm is not in default. Hence, even though the project would increase firm value,
existing shareholders will not want the firm to take it because it will not benefit them. The only way
the firm would take the project is if shareholders can renegotiate with creditors so that they get more
of the payoff of the project. If such a renegotiation is possible, it is often difficult and costly.
Sometimes, however, no such renegotiation succeeds. When the firm is valued by the capital markets,
its value is discounted because of the probability that it might not take valuable projects because its
financial health might be poor. Hence, reducing this probability through risk management increases
firm value as long as risk management is cheap.
Both situations we discussed in this section arise because the firm has too much debt. Not
surprisingly, in such cases the firm is said to have a debt overhang. A debt overhang induces
shareholders to increase risk and to avoid investing in valuable projects. The probability that the firm
might end up having a debt overhang in the future reduces its value today. Consequently, risk
management that reduces this probability increases firm value today. The costs associated with a debt
overhang are costs of financial distress. As with the costs of financial distress, the present value of
these costs could be reduced by having less debt. We saw, however, that debt has value and that it
is generally not an optimal strategy for a firm to be an allequity firm. As long as a firm has some debt
and some risk, there is some possibility that it might end up having a debt overhang.
Section 3.5.2. Information asymmetries and agency costs of managerial discretion.
Most of our analysis derives benefits from risk management that depend on the existence of
Chapter 3, page 39
debt. Without debt of some sort, there are no bankruptcy costs and no tax benefits of debt to protect.
Generally, one thinks of costs of financial distress as costs resulting from difficulties the firm has to
cope with its debt service. In section 3.4., we saw that the existence of valuable stakeholders could
lead a firm to want to reduce risk. That argument for risk management does not depend on the
existence of debt. Lets consider here another situation where risk management creates value even
for a firm that has no debt. Firm value fluctuates randomly. Hence, sometimes it will fall
unexpectedly. The problem with a low firm value is that it limits the firms ability to invest. Firms with
limited net worth can sometimes raise extremely large amounts of money, but typically they cannot.
Hence, if such firms want to invest massively, they may have trouble to do so.
The key problem management faces when trying to raise funds is that it knows more about
the firms projects than the outsiders it is dealing with. A situation where one party to a deal knows
more than the other is called a situation with an information asymmetry. Suppose that the firms
net worth with its existing projects is $10M. Management knows that by investing $100M the firm
can double its net worth. All management has to do then is find investors who will put up $100M.
If you are such an investor, you have to figure out the distribution of the return on your investment
based on the information provided to you by management. Generally, management has much to gain
by investing in the project. For instance, management compensation and perquisites increase with firm
size. Small firms do not have planes for managers; large firms do. As a result, management will be
enthusiastic about the project. This may lead to biases in its assessment and a tendency to ignore
problems. Even if management is completely unbiased and reveals all of the information it has to
potential investors, the potential investors cannot easily assess that management is behaving this way.
Potential investors know that often, management has enough to gain from undertaking the project
Chapter 3, page 40
that it might want to do so even if the chance of success is low enough that the project is a negative
net present value project. The costs associated with managements opportunity to undertake projects
that have a negative net present value when it is advantageous for it to do so are called the agency
costs of managerial discretion. In the absence of managerial discretion, management would not have
this opportunity. Managerial discretion has benefits  without it, management cannot manage. It has
costs also, however. With managerial discretion, management pursues its own objectives, which
creates agency costs  the agents interests, management, are not aligned with the interests of those
who hire management, the principals, namely the shareholders.
Agency costs of managerial discretion make it harder for the firm to raise funds and increase
the costs of funds. If outsiders are not sure that the project is as likely to pay off as management
claims, they require a higher expected compensation for providing the funds. Clearly, if management
was truthful about the project, having to pay a higher expected compensation reduces the profits from
the project. This higher expected compensation could lead to a situation where the project is not
profitable because the cost of capital for the firm is too high because of costs of managerial discretion.
The firm could use a number of approaches to try to reduce the costs of managerial discretion
and hence reduce the costs of the funds raised. For instance, it could entice a large shareholder to
come on board. This shareholder would see the company from the inside and would be better able
to assess whether the project is valuable. However, if the firm could have invested in the project in
normal times more easily but has a low value now because of adverse developments unrelated to the
value of the project, a risk management strategy might have succeeded in avoiding the low firm value
and hence might have enabled the firm to take the project. For instance, if the firms value is much
larger, it might be able to borrow against existing assets rather than having to try to borrow against
Chapter 3, page 41
the project.
A risk management strategy that avoids bad outcomes for firm value might help the firm to
finance the project for another reason. Investors who look at the evolution of firm value have to
figure out what a loss in firm value implies. There could be many possible explanations for a loss in
firm value. For instance, firm value could fall because its stock of raw materials fell in value, because
the economy is in a recession, because a plant burned down, or because management is incompetent.
In general, it will be difficult for outsiders to figure out exactly what is going on. They will therefore
always worry that the true explanation for the losses is that management lacks competence.
Obviously, the possibility that management is incompetent makes it more difficult for management
to raise funds if is competent but outsiders cannot be sure. By reducing risk through risk
management, the firm becomes less likely to be in a situation where outsiders doubt the ability of
management.
Section 3.5.3. The cost of external funding and Homestake.
Our analysis shows that external funding can be more expensive than predicted by the CAPM
because of agency costs and information asymmetries. Agency costs and information asymmetries
create a wedge between the costs of internal funds and the costs of external funds. This wedge can
sometimes be extremely large. The box on Warren Buffet and Catastrophe Insurance provides an
example where taking on diversifiable risk is extremely rewarding. For Homestake, however, this is
not an issue. It turns out that Homestake could repay all its debt with its cash reserves, so that debt
overhang is not an issue. The firm also has enough cash that it could finance large investments out
of internal resources.
Chapter 3, page 42
Section 3.6. Summary.
In this chapter, we have investigated four ways in which firms without risk management can
leave money on the table:
1. These firms bear more direct bankruptcy costs than they should.
2. These firms pay more taxes than they should.
3. These firms pay more to stakeholders than they should.
4. These firms sometimes are unable to invest in valuable projects.
In this chapter, we have identified benefits from risk management that can increase firm value. In the
next chapter, we move on to the question of whether and how these benefits can provide the basis
for the design of a risk management program.
Chapter 3, page 43
Key concepts
Bankruptcy costs, financial distress costs, tax shield of debt, optimal capital structure, stakeholders,
debt overhang, agency costs of managerial discretion, costs of external funding.
Chapter 3, page 44
Review questions
1. How does risk management affects the present value of bankruptcy costs?
2. Why do the tax benefits of risk management depend on the firm having a tax rate that depends on
cash flow?
3. How do carryback and carryforwards affect the tax benefits of risk management?
4. How does risk management affect the tax shield of debt?
5. Does risk management affect the optimal capital structure of a firm? Why?
6. When does it pay to reduce firm risk because a large shareholder wants the firm to do it?
7. How does the impact of risk management on managerial incentives depend on the nature of
managements compensation contract?
8. Is risk management profitable for the shareholders of a firm that has a debt overhang?
9. How do costs of external funding affect the benefits of risk management?
Chapter 3, page 45
Literature note
Smith and Stulz (1985) provide an analysis of the determinants of hedging policies that covers the
issues of bankruptcy costs, costs of financial distress, stakeholders, and managerial compensation.
Stulz (1983) examines optimal hedging policies in a continuoustime model when management is risk
averse. Diamond (1981) shows how hedging makes it possible for investors to evaluate managerial
performance more effectively. DeMarzo and Duffie (1991) and Breeden and Viswanathan (1998)
develop models where hedging is valuable because of information asymmetries between managers and
investors. Froot, Scharfstein and Stein (1993) construct a model that enables them to derive explicit
hedging policies when firms would have to invest suboptimally in the absence of hedging because of
difficulties in securing funds to finance investment. Stulz (1990,1996) discusses how hedging can
enable firms to have higher leverage. Stulz (1990) focuses on the agency costs of managerial
discretion. In that paper, hedging makes it less likely that the firm will not be able to invest in valuable
projects, so that the firm can support higher leverage. In that paper, debt is valuable because it
prevents managers from making bad investments. Tufano (1998) makes the point that reducing the
need of firms to go to the external market also enables managers to avoid the scrutiny of the capital
markets. This will be the case if greater hedging is not accompanied by greater leverage.
Bessembinder (1991) and Mayers and Smith (1987) also analyze how hedging can reduce the
underinvestment problem. Leland (1998) provides a continuoustime model where hedging increases
firm value because (a) it increases the tax benefits from debt and (b) it reduces the probability of
default and the probability of incurring distress costs. Ross (1997) also models the tax benefits of
hedging in a continuoustime setting. Petersen and Thiagarajan (1998) provide a detailed comparison
of how hedging theories apply to Homestake and American Barrick.
3
The source is Kenneth Froot, The limited financing of catastrophe risk: An overview, in
The Financing of Property Casualty risks, University of Chicago Press, 1997.
Chapter 3, page 46
BOX
Warren Buffet and the Catastrophe Insurance
3
Lets look at an interesting example where the costs of external finance can be computed directly and
turn out to be much larger than predicted by the CAPM. There exists a market for catastrophe
insurance. In this market, insurers provide insurance contracts that pay off in the event of events such
as earthquakes, tornadoes, and so on. Insurance companies hedge some of their exposure to
catastrophes by insuring themselves with reinsurers. A typical reinsurance contract promises to
reimburse an insurance company for claims due to a catastrophe within some range. For instance, an
insurance company could be reimbursed for up to $1 billion of Californian earthquake claims in excess
of $2 billion. Catastrophe insurance risks are diversifiable risks, so that bearing these risks should not
earn a risk premium. This means that the price of insurance should be the expected losses discounted
at the riskfree rate. Yet, in practice, the pricing of reinsurance does not work this way.
Lets look at an example. In the Fall of 1996, Berkshire Hattaway, Warren Buffets company,
sold reinsurance to the California Earthquake Authority. The contract was for a tranche of $1.05
billion insured for four years. The annual premium was 10.75% of the annual limit, or $113M. The
probability that the reinsurance would be triggered was estimated at 1.7% at inception by EQE
International, a catastrophe risk modeling firm. Ignoring discounting, the annual premium was
therefore 530% the expected loss (530% is (0.1075/0.017)  1 in percent). If the capital asset pricing
Chapter 3, page 47
model had been used to price the reinsurance contract, the premium would have been $17.85M in the
absence of discounting and somewhat less with discounting.
How can we make sense of this huge difference between the actual premium and the premium
predicted by the capital asset pricing model? A reinsurance contract is useless if there is credit risk.
Consequently, the reinsurer essentially has to have liquid assets that enable it to pay the claims. The
problem is that holding liquid assets creates agency problems. It is difficult to make sure that the re
insurer will indeed have the money when needed. Once the catastrophe has occurred, the under
investment problem would prevent the reinsurer from raising the funds because the benefit from
raising the funds would accrue to the policy holders rather than to the investors. The reinsurer
therefore has to raise funds when the policy is agreed upon. Hence, in the case of this example, the
reinsurer would need  if it did not have the capital  to raise $1.05 billion minus the premium. The
investors would have to be convinced that the reinsurer will not take the money and run or take the
money and invests it in risky securities. Yet, because of the asset substitution problem, the reinsurer
has strong incentives to take risks unless its reputational capital is extremely valuable. In the absence
of valuable reputational capital, the reinsurer can gamble with the investors money. If the reinsurer
wins, it makes an additional profit. If it loses, the investors or the insurers clients lose.
There is another problem with reinsurance which is due to the information asymmetries and
agency costs in the investment industry. The reinsurer has to raise money from investors, but the
funds provided would be lost if a catastrophe occurs. Most investment takes place through money
managers that act as agents for individual investors. In the case of funds raised by reinsurance
companies, the money managers is in a difficult position. Suppose that he decides that investing with
a reinsurance firm is a superb investment. How can the individual investors who hire the money
Chapter 3, page 48
manager know that he acted in their interest if a catastrophe occurs? They will have a difficult time
deciding whether the money manager was right and they were unlucky or the money manager was
wrong. The possibility of such a problem will lead the money manager to require a much larger
compensation for investing with the reinsurance firm.
Berkshire Hataway has the reputational capital that makes it unprofitable to gamble with
investors money. Consequently, it does not have to write complicated contract to insure that there
will not be credit risk. Since it has already large reserves, it does not have to deal with the problems
of raising large amounts of funds for reinsurance purpose. Could these advantages be worth as much
as they appeared to be worth in the case of our example? Maybe not. However, there is no evidence
that there were credible reinsurers willing to enter cheaper contracts. With perfect markets, such re
insurers would have been too numerous to count.
Chapter 3, page 49
Figure 3.1. Cash flow to shareholders and operating cash flow.
The firm sells 1M ounces of gold at the end of the year and liquidates. There are no costs. The
expected gold price is $350.
Chapter 3, page 50
Figure 3.2. Creating the unhedged firm out of the hedged firm.
The firm produces 100M ounces of gold. It can hedge by selling 100M ounces of gold forward. The
expected gold price and the forward price are $350 per ounce. If the firm hedges and shareholders
do not want the firm to hedge, they can recreate the unhedged firm by taking a long position forward
in100M ounces of gold.
Chapter 3, page 51
Figure 3.3. Cash flow to shareholders and bankruptcy costs. The firm sells 1m ounces of gold
at the end of the year and liquidates. There are no costs. The expected gold price is $350.Bankruptcy
costs are $20M if cash flow to the firm is $250M. Expected cash flow to shareholders for unhedged
firm is 0.5 times cash flow if gold price is $250 plus 0.5 times cash flow if gold price is $450.
Chapter 3, page 52
Figure 3.4. Expected bankruptcy cost as a function of volatility.
The firm produces 100M ounces of gold and then liquidates. It is bankrupt if the price of gold is
below $250 per ounce. The bankruptcy costs are $20 per ounce. The gold price is distributed
normally with expected value of $350. The volatility is in dollars per ounce.
Chapter 3, page 53
Figure 3.5. Taxes and cash flow to shareholders.
The firm pays taxes at the rate of 50% on cash flow in excess of $300 per ounce. For simplicity, the
price of gold is either $250 or $450 with equal probability. The forward price is $350.
Chapter 3, page 54
100 200 300 400
305
310
315
320
325
330
Figure 3.6. Firm aftertax cash flow and debt issue.
The firm has an expected pretax cash flow of $350M. The tax rate is 0.5 and the riskfree rate is 5%.
The figure shows the impact on aftertax cash flow of issuing more debt, assuming that the IRS
disallows a deduction for interest of debt when the firm is highly likely to default.
After tax cash flow of hedged firm
Optimal amount of
debt, $317.073M
Principal amount of debt
Chapter 4: An integrated approach to risk management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Section 4.1. Measuring risk for corporations: VaR, CaR, or what? . . . . . . . . . . . . . . . . . 4
Section 4.1.1. The choice of a risk measure at a financial institution . . . . . . . . . . 4
Section 4.1.2. The choice of a risk measure for a nonfinancial institution . . . . . . 16
Section 4.1.3. CaR or VaR for nonfinancial firms? . . . . . . . . . . . . . . . . . . . . . . 19
Section 4.2. CaR, VaR, and firm value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Section 4.2.1. The impact of projects on VaR . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Section 4.2.2. CaR and project evaluation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
Section 4.2.3. Allocating the cost of CaR or VaR to existing activities . . . . . . . 29
Section 4.3. Managing firm risk measured by VaR or CaR . . . . . . . . . . . . . . . . . . . . . . 36
Section 4.3.1. Increase capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37
Section 4.3.2. Project choice . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Section 4.3.1.C. Derivatives and financing transactions . . . . . . . . . . . . . 41
Section 4.3.3. The limits of risk management . . . . . . . . . . . . . . . . . . . . . . . . . . 43
1. It is not rocket science . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
2. Credit risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43
3. Moral hazard . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Section 4.4. An integrated approach to risk management . . . . . . . . . . . . . . . . . . . . . . . 46
Literature note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Figure 4.1. Using the cumulative distribution function . . . . . . . . . . . . . . . . . . . . . . . . . 53
Figure 4.2. Frequency distribution of two portfolios over one year horizon . . . . . . . . . . 54
Figure 4.3. VaR as a function of trade size . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Box 4.1. VaR, banks, and regulators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Box 4.2. RAROC at Bank of America . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Technical Box 4.1. Impact of trade on volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Chapter 4, page 1
Chapter 4: An integrated approach to risk management
December 13, 1999
Ren M. Stulz 1998, 1999
Chapter 4, page 2
Chapter objectives
1. Introduce risk measures appropriate to financial and nonfinancial firms.
2. Define value at risk (VaR) and cash flow at risk (CaR).
3. Show how to use VaR and CaR to make investment decisions.
4. Demonstrate the use of VaR and CaR to evaluate the profitability of existing activities of a firm.
5. Investigate the strategies available to the firm to reduce the cost of risk.
6. Assess the limits of risk management.
Chapter 4, page 3
Chapter 3 showed that there are five major reasons why risk management can increase
shareholder wealth. These reasons are:
1. Risk management can decrease the present value of bankruptcy and financial distress costs.
2. It can make it more likely that the firm will be able to take advantage of valuable
investment opportunities.
3. It can decrease the present value of taxes paid by the corporation.
4. It can increase the firms debt capacity and allow it to make better use of the tax shield of
debt.
5. By reducing risk, risk management makes it possible for the firm to have large shareholders
that monitor management and to align managements incentives better with the objectives
of shareholders.
Chapter 3 provided us with a catalog of benefits from risk management. Though such a
catalog is an important starting point in understanding risk management, it is only the first step in the
process of finding out how these benefits can be captured by a corporation. One might be tempted
to say that to capture these benefits, risk should be managed to maximize the value of the
corporation. However, such a way to look at risk management is too general to be useful. For risk
management to be used to maximize firm value, one must concretely define how risk is measured and
how it is managed. This chapter presents a framework that makes it possible to do that.
In the first part of this chapter, we show how the benefits of risk management presented in
Chapter 3 lead to the choice of a risk measure. This risk measure depends on the characteristics of
Chapter 4, page 4
the firm. Armed with a risk measure, a firm can evaluate the impact of new projects on its risk and
take into account the contribution of existing activities to risk when it evaluates their profitability.
Having specified the choice of a risk measure, we then discuss the tools available for risk
management. Firms can manage their cost of total risk through equity, through their choice of
projects or through transactions in financial markets. We discuss the costs and benefits of these
various tools to manage the cost of risks and argue that derivatives are generally the most cost
effective approach for a corporation to manage its total risk.
Section 4.1. Measuring risk for corporations: VaR, CaR, or what?
In this section, we analyze the considerations that affect a firms choice of a risk measure.
To understand these considerations, we focus on two important concrete examples that allow us to
examine the tradeoffs involved in choosing risk measures. The first part of the section examines
financial institutions. The second part of the section analyzes the choice of a risk measure for non
financial corporations.
Section 4.1.1. The choice of a risk measure at a financial institution.
The analysis of chapter 3 allows us to understand how risk management makes it possible to
increase the value of a financial institution. Financial institutions generally have customers who are
also creditors. The owner of a checking account lends his money to the bank. The firm which enters
into a derivatives contract with an investment bank is a creditor of the bank if the firm expects to
receive a payment from the bank at maturity. The buyer of a life insurance policy owns a claim against
the insurance company from which she bought the policy. In general, the customers of a financial
Chapter 4, page 5
institution are extremely sensitive to its credit risk because they cannot diversify this risk.
Government guarantees for some types of financial institutions and some types of claims against
financial institutions can reduce the concerns about credit risk for some customers of financial
institutions. For instance, deposits of less than $100,000 are federally insured in the U.S. Government
guarantees shift concerns about credit risks partly from customers to regulatory agencies that have
to make up shortfalls.
An investor who buys bonds issued by a financial institution is in general willing to trade off
expected return and risk for these bonds. If the financial institution has high credit risk, the investor
holds the bonds as long as the expected return is high enough to compensate her for the credit risk.
Risky bonds are generally held as part of a diversified portfolio, so that the required risk premium
depends on the contribution of the bonds to the risk of the portfolio. Bondholders are not customers
of the financial institution.
Customers of financial institutions have a dramatically different attitude toward credit risk
than bondholders. An individual who is willing to hold risky bonds as part of a diversified portfolio
generally wants her checking account to have no risk. The reason for this is straightforward. If the
checking account has significant credit risk, a check of $100 is not sufficient to buy an object with
a price of $100. This is because the store that sells the object wants to be compensated for the credit
risk incurred between the moment the object is sold and the moment the check clears. Consequently,
each transaction made using a check drawn on the checking account would require a negotiation to
determine the appropriate compensation for credit risk paid to the person or firm that receives the
check. This would destroy the usefulness of the checking account, which is that checks are substitutes
for cash. A firm that enters a forward contract with a financial institution wants the forward contract
Chapter 4, page 6
to serve as an effective hedge. If the financial institution has substantial credit risk, it might not deliver
on the forward contract. This possibility would sharply decrease the usefulness of the forward
contract as a hedging device. Finally, consider the case of an insurance contract. No customer of an
insurance company would be willing to buy a lifeinsurance contract that costs half as much as other
insurance contracts but has a 0.5 probability of paying off because of credit risk.
It follows from this discussion that a small probability of default risk can have a dramatic
impact on the business of a financial institution. As default risk becomes significant, customers
withdraw their checking accounts, the derivatives business dries up, and the life insurance business
disappears. The value of a financial institution for its shareholders depends crucially on its ability to
retain old customers and acquire new ones. Shareholder wealth in a financial institution is fragile,
probably more so than at any other type of corporation. Because customers are creditors in financial
institutions, financial institutions are highly levered in comparison to other firms. The more business
a financial institution has for a given amount of capital, the greater its leverage. An adverse shock to
a financial institution can therefore make its equity disappear quickly as customers react to the shock
by withdrawing their business. Costs of financial distress are very large for financial institutions
because generally the mere hint of the possibility of financial distress can create a run on a financial
institution that eliminates its value as an ongoing business.
The fact that a financial institutions ability to do business depends so critically on its
creditworthiness means that it must control its risks with extreme care. It must make sure that they
are such that the probability that the financial institution will lose customers because of its own credit
risk is very small. The analysis of why a financial institution benefits from risk management therefore
suggests that the focus of the risk management effort has to be on computing, monitoring, and
Chapter 4, page 7
managing a measure of risk that corresponds to the probability that the financial institution will lose
customers because of credit risk.
To figure out an appropriate measure of risk, lets consider the type of event that could make
the financial institution risky for its customers. Lets say that this financial institution is a bank. Most
of its assets are loans and traded securities; it has deposits and debt in its liabilities. An asset or
liability is markedtomarket when its value in the firms balance sheet corresponds to its market
value and when changes in its market value affect the firms earnings. Some assets and liabilities, the
traded securities, are markedtomarket; other assets and liabilities are kept at book value. For assets
and liabilities markedtomarket, their change in value can be observed directly and corresponds to
a gain or loss for the institution that affects its earnings directly. If the net value of the traded
securities falls sharply, the institution is likely to have difficulties in meeting its obligations. Financial
institutions also typically have derivative positions that at a point in time may have no value, yet could
require them to make large payments in the future. We can think of all the positions in traded
securities and derivatives as the banks portfolio of traded financial instruments.
The probability of a value loss that creates serious problems for an institution cannot be
reduced to zero. As long as the institution has a portfolio of risky traded financial instruments and
is levered, it cannot be completely safe. A key goal of risk management then is to keep the probability
that the firm will face an exodus of its customers low enough that its customers are not concerned.
This means that the probability of losses above a critical size from traded financial instruments has
to be kept low. To insure that this is the case, the firm can specify this critical loss size and the
probability that it will be exceeded that it can tolerate. For instance, the firm could decide that the
probability of having a loss exceeding 10% of the value of its traded financial instruments over a day
Chapter 4, page 8
must be 0.05. What this means is that 95% of the time, the return of the portfolio of traded financial
instruments must be higher than 10%. Given the firms existing portfolio of traded financial
instruments, it can find out the probability of a loss of 10% or more over one day. To compute this
probability, it has to know the distribution of the gains and losses of the portfolio. Lets assume that
the portfolios return has a normal distribution. As a portfolio includes derivatives that have option
components, the distribution of its return is generally not normal. Consequently, evaluating the risk
of portfolios whose returns are not normal is an important issue in risk management. We will learn
how to do this in detail in later chapters. If returns are not normally distributed, however, the
computations in this chapter relying on the normal distribution would be changed but the general
principles we focus on here would not.
Lets see how we can use the analysis of chapter 2 to find the probability that the portfolio
will make a loss of at least 10% over one day. The probability that the return will be lower than some
number x over a day, Prob[Return < x], is given by the cumulative normal distribution function
evaluated at x. To use the cumulative normal distribution, we need to know the expected return and
its volatility. Lets assume that the expected return is 10% and the volatility is 20%. Figure 4.1. shows
how we can use the cumulative normal distribution to find the probability that the portfolio will make
a loss of at least 10% over one day. We pick the return of 10% and read the probability on the
vertical axis corresponding to the level of the cumulative normal probability distribution. We find that
the probability is 0.16. Alternatively, by setting the probability equal to 0.05, we can get on the
horizontal axis the number x such that the return will be less than x with probability of 0.05. For the
probability 0.05, x is equal to 33%, so that the firm has a 0.05 probability of losing at least 33%. If
the return of the portfolio of traded financial instruments is distributed normally, then knowing the
1
The zth quantile of a random variable x is the number q that satisfies Prob(x < q) = z.
Chapter 4, page 9
volatility of the return and the expected return provides us with all the information we need to
compute any statistic for the distribution of gains and losses.
Put Figure 4.1. here
Suppose that the financial institution follows the approach just described. It has a portfolio
of traded financial instruments worth $2B, so that a 10% loss is equal to $200M. The institution finds
that it has a probability of 0.05 of making a loss of at least 23%, or $460M. If the bank had decided
that it could only afford to have a loss of $200M or more with a probability of 0.05, the computation
of the risk of the portfolio of traded assets tells us that the financial institution has too much risk.
Consequently, the financial institution has to decide what to do to reduce its risk. An obvious solution
is to reduce the size of the portfolio of traded financial instruments. Alternatively, the financial
institution can hedge more if appropriate hedging instruments are available. Hence, the risk measure
allows the financial institution to decide how to manage the risk its portfolio of traded financial
instruments so that shareholder wealth is maximized.
The risk measure defined as the dollar loss x that will be exceeded with a given probability
over some measurement period is called value at risk or VaR. With this definition, the VaR can be
computed for a firm, a portfolio, or a trading position. The VaR at the probability level of z% is the
loss corresponding to the zth quantile of the cumulative probability distribution of the value change
at the end of the measurement period.
1
Consequently, we define:
Value at Risk
Value at risk or VaR at z% is the dollar loss that has a probability z% of being exceeded over the
Chapter 4, page 10
measurement period. Formally, VaR is the number such that Prob[Loss > VaR] = z%.
Note that this definition makes no assumption about the distribution function of the loss. In the
financial institution example, the measurement period was one day, so that VaR was $460M at the
probability level of 5% using the normal distribution. Throughout the book, we will use z% as 5%
unless we specify otherwise. If VaR is a loss that is exceeded with probability of z%, there is a (1z)%
probability that the loss will not be exceeded. We can therefore consider an interval from VaR to
plus infinity such that the probability of the firms gain belonging to that interval is (1z)%. In
statistics, an interval constructed this way is called a onesided confidence interval. As a result, one
can also think of VaR as the maximum loss in the (1z)% confidence interval, or in short, the
maximum loss at the (1z)% confidence level. If we compute the VaR at the 5% probability level, it
is therefore also the maximum loss at the 95% confidence level. We are 95% sure that the firms gain
will be in the interval from VaR to plus infinity.
The VaR risk measure came about because the CEO of JP Morgan, Dennis Weatherstone at
the time, wanted to know the banks risk at the end of the trading day. He therefore asked his staff
to devise a risk measure that would yield one number that could be communicated to him at 4:15 pm
each trading day and would give him an accurate view of the risk of the bank. His perspective on risk
was similar to the one we developed in this chapter. He wanted to have a sense of the risk of bad
outcomes that would create problems for the bank. In chapter 2, we considered three risk measures.
These measures were volatility, systematic risk, and unsystematic risk. None of these three measures
provides a direct answer to the question that Dennis Weatherstone wanted answered, but VaR does.
In general, there is no direct relation between VaR and these three risk measures. (We will see below
2
This example is due to Delbaen, Eber, and Heath (1997).
Chapter 4, page 11
that the normal distribution is an exception to this statement.) In particular, with complicated
securities, it is perfectly possible for volatility to increase and VaR to fall at the same time.
The use of volatility as a risk measure leads to a paradox that demonstrates neatly why it is
inappropriate.
2
Suppose that a corporation has the opportunity to receive a lottery ticket for free that
pays off in one year. This ticket has a small chance of an extremely large payoff. Otherwise, it pays
nothing. If the firm accepts the free lottery ticket, its oneyear volatility will be higher because the
value of the firm now has a positive probability of an extremely large payoff that it did not have
before. A firm that focuses on volatility as its risk measure would therefore conclude that taking the
lottery ticket makes it worse off if the volatility increase is high enough. Yet, there is no sense in
which receiving something that has value for free can make a firm worse off. The firms VaR would
not be increased if the firm accepts the free lottery ticket.
Figure 4.2. provides an illustration of how return volatility can fail to convey the information
that Dennis Weatherstone wanted. We show the return frequency distribution for two different
portfolios. These two portfolios are constructed to have the same return volatility of 30%. One
portfolio holds common stock and has normally distributed returns. The other portfolio holds the risk
free asset and options and does not have normally distributed returns. Even though these two
portfolios have the same return volatility, the portfolio with options has a very different VaR from
the portfolio without options. (To learn how to compute the VaR of a portfolio with options, we will
have to wait until chapter 14.) Lets assume we invest $100M in each portfolio and hold this position
for one year. The stock portfolio has a VaR of $41.93M, while the portfolio holding the riskfree
asset and options has a VaR of $15M.
Chapter 4, page 12
In our example, volatility is not useful to evaluate the risk of bad outcomes. This is because
the portfolios have very different lowertail returns since the worst returns of the portfolio with
options are much less negative than the worst returns of the stock portfolio. Consequently, bad
returns for the stock portfolio might bankrupt the bank but bad returns for the portfolio with options
might not. Systematic or unsystematic risk capture the downside risk that matters for the bank even
less than volatility. To construct Figure 4.2., we only need the volatility and the expected return of
the stock. Knowledge of the betas of the portfolios is not required. Hence, these betas could be
anything. This means that beta cannot help us understand the distribution of bad outcomes. With
different betas, these portfolios would have very different unsystematic risk, but we could change
betas so that Figure 4.2. would remain the same. Hence, had JP Morgans staff provided Dennis
Weatherstone with the systematic risk of the bank or its unsystematic risk, the information would not
have answered the question he asked and would not have been useful to him.
The plots in Figure 4.2. show that it is crucially important to understand the distribution of
the returns of the positions of the bank to compute its VaR. To answer Dennis Weatherstones
question, therefore, his staff had to know the value of all the markedtomarket positions of the bank
at the end of the trading day and had to have a forecast of the joint distribution of the returns of the
various securities held by the bank. As we will see in later chapters, forecasting the distribution of
returns and computing VaR can be a challenging task when the securities are complicated.
Computing the VaR is straightforward when the returns are normally distributed. We know
from chapter 2 that the fifth quantile of a normally distributed random variable is equal to the
expected value of that variable minus 1.65 times the volatility of that random variable. Hence, if the
return of a portfolio is distributed normally, the fifth quantile of the return distribution is the expected
Chapter 4, page 13
return minus 1.65 times the return volatility. For changes computed over one day, this number is
generally negative. The return loss corresponding to the fifth quantile is therefore the absolute value
of this negative change. Consider a bank whose portfolio of traded assets has an expected return of
0.1% and a volatility of 5%. The fifth quantile of the return distribution is 0.1%  1.65*5%, or 
8.15%. Hence, if the banks value is $100M, the VaR is 8.15% of $100m or $8.15M.
In general, the expected return over one day is small compared to the volatility. This means that
ignoring the expected return has a trivial impact on an estimate of the VaR for one day. In practice,
therefore, the expected return is ignored. With normally distributed returns and zero expected change,
the formula for VaR is:
Formula for VaR when returns are distributed normally
If the portfolio return is normally distributed, has zero mean, and has decimal volatility F over the
measurement period, the 5% VaR of the portfolio is:
VaR = 1.65* F *Portfolio value
The VaR in the example would then be 1.65*0.05*$100M, or $8.25M. Note that this formula shows
that, for the normal distribution, there is a direct relation between volatility and VaR since VaR
increases directly with volatility. In general, however, as shown in Figure 4.2., portfolios with same
return volatilities can have different VaRs and portfolios with the same VaRs can have different
volatilities.
An important issue is the time period over which the VaR should be computed. Remember
Chapter 4, page 14
that the reason for computing the VaR is that the financial institution wants to monitor and manage
the size of potential losses so that the probability that it will face financial distress is low. The
economically relevant distribution of losses is the one that corresponds to losses that the financial
institution can do nothing about after having committed to a portfolio of financial instruments. If a
financial institution can measure its risk and change it once a day, the relevant measure is the oneday
VaR. At the end of a day, it decides whether the VaR for the next day is acceptable. If it is not, it
takes actions to change its risk. If it is acceptable, there is nothing it can do about the VaR until the
next day. At the end of the next day, it goes through the process again. For such an institution,
a VaR cannot be computed over a shorter period of time because of lack of data or because there is
nothing the institution can do with the estimate if it has it. It is not clear how one would compute a
oneyear VaR and what it would mean for such an institution. The bank could compute a oneyear
VaR assuming that the VaR over the next day will be maintained for a year. However, this number
would be meaningless because the financial institutions risk changes on a daily basis and because,
if the financial institution incurs large losses or if its risk increases too much, it will immediately take
steps to reduce its risk. If a financial institution cannot do anything to change the distribution of the
value changes of its portfolio for several days because it deals in illiquid markets, the risk measure
has to be computed over the time horizon over which it has no control over the distribution of losses.
Hence, the period over which the VaR is computed has to reflect the markets in which the firm deals.
Generally, the VaR computed by financial institutions takes into account only the derivative
price changes due to market changes, ignoring counterparty risks. For instance, if a bank has a
forward currency contract on its books, it will use the change in the value of the forward contract for
Chapter 4, page 15
the VaR computation using a forward currency contract valuation model that ignores the
creditworthiness of the counterparty to the forward contract and computes the forward exchange rate
without paying attention to the counterparty. Consequently, VaR generally ignores credit risks. This
means that VaR does not measure all risks the bank faces. Credit risks are generally a substantial
source of risk for banks because of their loan portfolio. However, banks do not have the information
to compute changes in the riskiness of their loan portfolio on a daily basis. Loans are not marked to
market on a daily basis and firms release accounting data that can be used to evaluate the credit
worthiness of loans generally on a quarterly basis. This means that a bank typically estimates credit
risks over a different period of time than it measures market risks. We will discuss in detail how credit
risks are measured in chapter 18. The VaR measure plays an important role in financial institutions
not only as a risk management tool, but also as a regulatory device. Box 4.1. VaR and regulators
shows that large banks have to use VaR.
Put Box 4.1. here
Financial firms have other risks besides market and credit risks. Lots of things can go wrong
in the implementation of firm policies. An order might be given to an individual to make a specific
transaction, perhaps to hedge to reduce the VaR, and the individual can make a mistake. A
standardized contract used by a financial institution might have a clause that turns out to be invalid
and this discovery creates large losses for the financial institution. An individual might find a problem
in the accounting software of the bank which allows her to hide losses in a trading position. These
types of problems are often included under the designation of operational risks. These risk are harder,
if not impossible, to quantify. Yet, they exist. Generally, these risks cannot be reduced through
financial transactions. The best way to reduce such risks is to devise procedures that prevent mistakes
Chapter 4, page 16
and make it easier to discover mistakes. Though the design of such procedures is very important, we
have little to say about this topic in this book. The one dimension of operational risk we focus on has
to do with risk measurement.
Section 4.1.2. The choice of a risk measure for a nonfinancial institution.
Lets now consider a manufacturing firm that exports some of its production. The firm has
foreign currency receivables. Furthermore, an appreciation of the domestic currency reduces its
international competitiveness. Consequently, the firm has exposure to foreign exchange rate risks. For
simplicity, it does not currently hedge, does not have derivatives, and does not have a portfolio of
financial assets. To start the discussion, we assume that it cannot raise outside funds. This firm will
view its main risk as the risk that it will have a cash flow shortfall relative to expected cash flow that
is large enough to endanger the firms ability to remain in business and finance the investments it
wants to undertake. Generally, a bad cash flow for a week or a month is not going to be a problem
for such a firm. Cash flows are random and seasonal. Some weeks or some months will have low cash
flows. A firm has a problem if bad cash flows cumulate. This means that a firm is concerned about
cash flows over a longer period of time, a year or more. A poor cash flow over a long period of time
will be a serious problem. Consequently, in measuring risk, the firm wants to know how likely it is
that it will have a cash flow shortfall that creates problems over a relevant period of time.
Lets say that a firm is concerned about the risk of its cash flow over the coming fiscal year.
It decides to focus on cash flow over the coming fiscal year because a low cash flow by the end of
that year will force it to change its plans and will therefore be costly. It has the funds available to
carry on with its investment plans for this year and it has enough reserves that it can ride out the year
Chapter 4, page 17
if cash flow is poor. To evaluate the risk that the firms cash flow will be low enough to create
problems, the firm has to forecast the distribution of cash flow.
If a specific cash flow level is the lowest cash flow the firm can have without incurring costs
of financial distress, the firm can use the cumulative distribution of cash flow to find out the
probability of a cash flow lower than this threshold. Alternatively, the firm can decide that it will not
allow the probability of serious problems to exceed some level. In this case, it evaluates the cash flow
shortfall corresponding to that probability level. If the cash flow shortfall at that probability level is
too high, the firm has to take actions to reduce the risk of its cash flow. This approach is equivalent
to the VaR approach discussed in the first part of this section, except that it is applied to cash flow.
By analogy, the cash flow shortfall corresponding to the probability level chosen by the firm is called
cash flow at risk, or CaR, at that probability level. A CaR of $100m at the 5% level means that there
is a probability of 5% that the firms cash flow will be lower than its expected value by at least
$100m. We can therefore define cash flow at risk as follows:
Cash flow at risk
Cash flow at risk (CaR) at z% or CaR is a positive number such that the probability that cash flow
is below its expected value by at least that number is z%. Formally, if cash flow is C and expected
cash flow is E(C), we have:
Prob[E(C)  C > CaR] = z%
Throughout the book, we use z% as 5% unless we specify otherwise. Lets look at an
Chapter 4, page 18
example of these computations. Consider a firm that forecasts its cash flow for the coming year to
be $80M. The forecasted volatility is $50M. The firm believes that the normal distribution is a good
approximation of the true distribution of cash flow. It wants to make sure that the probability of
having to cut investment and/or face financial distress is less than 0.05. It knows that it will be in this
unfortunate situation if its cash flow is below $20M. Hence, the firm wants the probability that its
cash flow shortfall exceeds $60M (expected cash flow of $80M minus cash flow of $20M) to be at
most 0.05. Using our knowledge of the normal distribution, we know that the CaR is equal to 1.65
times volatility, or 1.65*$50M, which corresponds to a cash flow shortfall of $82.5M. This means
that there is a probability 0.05 that the cash flow shortfall will be at least $82.5M or, alternatively,
that cash flow will be lower than $2.5M (this is $80M minus $82.5M). Since the CaR exceeds the
firms target, the cash flow is too risky for the firm to achieve its goal. It must therefore take actions
that reduce the risk of cash flow and ensure that it will earn at least $20M 95% of the time.
CaR is a risk measure for nonfinancial firms that is very much in the spirit of VaR. Whereas
the use of VaR is wellestablished and standardized, the same is not the case for CaR. The reason for
this is that there is much more diversity among nonfinancial firms than there is among financial firms.
With financial firms, it is generally clear that one has to focus on their value and the risk that their
value will fall because of adverse changes in the trading positions they have. The CaR measure
addresses the risk of cash flow and is generally computed for one year. This raises the question of
whether it makes sense for a firm to compute the risk of cash flow rather than the risk of firm value.
A corporation that hedges its whole value effectively hedges the present value of cash flows.
Consequently, it hedges not only the cash flow of this year but also the cash flow of future years.
There is much debate about whether nonfinancial corporations should hedge their value or their cash
Chapter 4, page 19
flows over the near future. This amounts to a debate on whether nonfinancial corporations should
compute CaR or a measure like VaR for the whole firm based on the risk of the present value of
future cash flows.
Section 4.1.3. CaR or VaR for nonfinancial firms?
To analyze whether a corporation should hedge cash flow or value, first consider a firm for
which focusing on the cash flow of the coming year is the solution that maximizes firm value. This
will be the case for a firm whose ability to take advantage of its growth opportunities depends solely
on its cash flow because it cannot access external capital markets. In this simple situation, the firm
has to manage the risk of its cash flow for the coming year to ensure that it can invest optimally. One
would expect such a firm to be more concerned about unexpectedly low cash flow than unexpectedly
high cash flow. With an unexpectedly low cash flow, the firm can incur costs of financial distress and
may have to cut investment. CaR provides a measure of the risk of having a cash flow shortfall that
exceeds some critical value. It is therefore an appropriate risk measure for such a firm.
Lets consider how the reasoning is changed if the firm has other resources to finance
investment. This will be the case if (a) the firm has assets (including financial assets) that it can sell
to finance investment and/or (b) it has access to capital markets. It is straightforward that if the firm
has assets it can liquidate, especially financial assets, then it may choose to do so if its cash flow is
low. Consequently, when it computes risk, it has to worry about the risk of the resources it can use
to invest at the end of the year. The firm will have to reduce investment if it simultaneously has a low
cash flow from operations and the value of the assets that can be liquidated to finance capital
expenditures is low. The CaR can be extended in a straightforward way in this case. Instead of
Chapter 4, page 20
focusing on cash flow from operations, the firm computes cash flow as the sum of cash flow from
operations plus the change in value of the assets that can be used to finance investment. It then
computes the CaR on this measure of cash flow. Note, however, that the firms earnings statement
cannot be used to compute this cash flow measure if financial assets are not marked to market.
If a firm has access to capital markets, then it has resources to finance next years investment
in addition to this years cash flow. Such a firm has to worry about its ability to raise funds in public
markets. If its credit is good enough, it will be able to raise funds at low cost. If its credit deteriorates,
the firm may find it too expensive to access capital markets. To the extent that the firms credit does
not depend only on the coming years cash flow, it is not enough for the firm to measure the risk of
this years cash flow. The firm also has to focus on the risk of the assets that it can use as collateral
to raise funds. Generally, firm value will be an important determinant of a firms ability to raise funds.
The firms risk measure has to take into account the change in its ability to raise funds. If the firm
can freely use the capital markets to make up for cash flow shortfalls as long as its value is sufficiently
high, then the firms relevant risk measure is firm value risk. A firms value is the present value of its
cash flows. This means that firm value risk depends on the risk of all future cash flows. The
appropriate measure of firm value risk is firm VaR, namely the loss of firm value that is exceeded with
probability 0.05. Chapter 8 provides techniques to compute risk measures for nonfinancial firms when
the normal distribution cannot be used.
We considered two extreme situations. One situation is where the firm has free access to
capital markets, so that it computes a VaR measure. The other situation is where the firms ability to
carry on its investment program next year depends only on the cash flow of this year. In this case, the
firm computes CaR. Most firms are between these extreme situations, so that a case can be made to
Chapter 4, page 21
use either one of the risk measures depending on the firms situation.
Section 4.2. CaR, VaR, and firm value.
Lets now look at a firm that has figured out how to measure its risk. All actions this firm
takes have the potential to affect its risk. This means that the firm has to evaluate its actions in light
of their impact on its risk measure. If the firm cares about risk measured by CaR or VaR, a project
that a firm indifferent to such risk might take may not be acceptable. Also, the firm might choose to
take some projects because they reduce its risk measure. This means that computing the NPV of a
project using the CAPM and taking all positive NPV projects is not the right solution for a firm that
is concerned about CaR or VaR. In this section, we consider how firms choose projects when CaR
or VaR is costly. We then show how firms should evaluate the profitability of their activities when
Car or Var is costly.
Section 4.2.1. The impact of projects on VaR.
Consider the case where a firm has a portfolio with securities that have normally distributed
returns. In this case, the VaR is equal to the dollar loss corresponding to the return equal to the
expected return of the portfolio minus 1.65 times the volatility of the portfolio. In this context, one
can think of a project as a trade which involves investing in a new security and financing the
investment with the sale of holdings of a security in the portfolio. This trade affects both the expected
return of the portfolio and its volatility.
In chapter 2, we showed how to compute the expected return and the volatility of a portfolio.
We saw that the change in the expected return of the portfolio resulting from buying security i and
Chapter 4, page 22
( )
ip jp p
* w*Vol(R Volatility impact of trade )
selling security j in same amounts is equal to the expected return of security i minus the expected
return of security j times the size of the trade expressed as a portfolio share )w, (E(R
i
)  E(R
j
))*)w.
We discussed in chapter 2 also how a small change in the portfolio share of a security affects the
volatility of the portfolio. We saw that the impact of the small change on the volatility depends on
the covariance of the return of the security with the return of the portfolio. We demonstrated there
that a trade that increases the portfolio share of a security that has a positive return covariance with
the portfolio and decreases the portfolio share of a security that has a negative return covariance with
the portfolio increases the volatility of the portfolio. Hence, such a trade has a positive volatility
impact. Denote the portfolio we are considering by the subscript p, remembering that this is an
arbitrary portfolio. The volatility impact of a trade that increases the portfolio share of security i in
the portfolio by )w and decreases the portfolio share of security j by the same amount has the
following impact on the volatility of the portfolio:
(4.1.)
(Technical Box 4.1. gives the exact derivation of the formula if needed.) $
ip
is the ratio of the
covariance of the return of security i with the return of portfolio p and of the variance of the return
of portfolio p. If portfolio p is the market portfolio, $
ip
is the CAPM beta, but otherwise $
ip
differs
from the CAPM beta. Lets assume that the return of the portfolio is normally distributed. If the
expected return of the portfolio is assumed to be zero, the VaR impact of the trade is then 1.65 times
the volatility impact of the trade times the value of the portfolio since VaR is 1.65 times volatility
times the value of the portfolio. If the trade increases the expected return of the portfolio, this
Chapter 4, page 23
VaR impact of trade
(E(R ) E(R )) * w*W ( ) *1.65*Vol(R ) * w*W
i j ip jp p
+
increase decreases the VaR because all possible portfolio returns are increased by the increase in
expected return. Let W be the initial value of the portfolio. The VaR impact of the trade is therefore:
(4.2.)
In other words, a trade increases the VaR of a portfolio if the asset bought has a greater beta
coefficient with respect to the portfolio than the asset sold and if it has a lower expected return. The
role of beta is not surprising since we know that beta captures the contribution of an asset to the risk
of a portfolio.
When deciding whether to make the trade, the firm has to decide whether the expected return
impact of the trade is high enough to justify the VaR impact of the trade. To make this decision, the
firm has to know the cost it attaches to an increase in VaR. We assume that the increase in the total
cost of VaR can be approximated for small changes by a constant incremental cost of VaR per unit
of VaR, which we call the marginal cost of VaR per unit. A firm that knows how much it costs to
increase VaR can then make the decision based on the expected gain of the trade net of the increase
in the total cost of VaR resulting from the trade:
Expected gain of trade net of increase in total cost of VaR =
Expected return impact of trade*Portfolio value
 Marginal cost of VaR per unit*VaR impact of trade (4.3.)
From the discussion in the first part of this section, an increase in VaR makes it more likely that the
Chapter 4, page 24
[ ]
(1/ 3) *0.1 (1/ 3) *0.4 (1/ 3) *0.6 2*(1/ 3) *(1/ 3) *0.4*0.4*0.6
0.1938
2 2 2 2 2 2
0.5
+ +
firm will face financial distress costs if it does not take any actions. The marginal cost of VaR per unit
captures all the costs the firm incurs by increasing VaR by a dollar. These costs might be the greater
costs of financial distress or might be the costs of the actions the firm takes to avoid having an
increase in the probability of financial distress. We consider these actions in the next section.
Lets consider an example. A firm has a portfolio of $100M consisting of equal investments
in three securities. Security 1 has an expected return of 10% and a volatility of 10%. Security 2 has
an expected return of 20% and a volatility of 40%. Finally, security 3 has an expected return of 25%
and a volatility of 60%. Security 1 is uncorrelated with the other securities. The correlation coefficient
between securities 2 and 3 is 0.4. Using the formula for the expected return of a portfolio, we have:
(1/3)*0.1 + (1/3)*0.2 + (1/3)*0.25 = 0.1833
The formula for the volatility of a portfolio gives us:
The VaR of the firm is $13.647M. It is 13.647% of the value of the portfolio because the return
corresponding to the fifth quantile of the distribution of returns is 0.1833  1.65*0.1938 or 13.647%.
Consider now the impact of a trade where the firm sells security 3 and buys security 1 for an amount
corresponding to 1% of the portfolio value, or $1m. The expected return impact of the trade is:
(0.1  0.25)*0.01 = 0.0015
( )
Cov(R , R ) Cov(R , (1/ 3)*R (1/ 3)*R (1/ 3)*R )
(1/ 3)* Var(R ) Cov(R , R ) Cov(R , R )
(1/ 3)*(0.01+ 0 + 0)
0.0033
2 m 2 1 2 3
1 1 2 1 3
+ +
+ +
3
The covariance is computed as follows:
Chapter 4, page 25
This means that the trade decreases the expected return of the portfolio by 0.15%. To compute the
VaR impact, we have to compute the beta of each security with respect to the portfolio. This requires
us to know the covariance of each security with respect to the portfolio. The covariances of the
securities with the portfolio are Cov(R
1
,R
p
) = 0.0033 and Cov(R
3
,R
p
) = 0.088.
3
To compute the VaR
impact, we can obtain the beta of assets 1 and 3. The beta of asset 1 is Cov(R
1
,R
p
)/Var(R
p
), or
0.0033/0.1938
2
, which is 0.088. The beta of asset 3 is 0.088/0.1938
2
, or 2.348. The VaR impact is
therefore:
[(0.10  0.25)*0.01 + (0.088  2.348)*1.65*0.1936*0.01]*$100M = $571,934
The trade reduces the firms VaR by $571,934. It also makes an expected loss of $150,000. Suppose
that the firm believes that the trade would allow it to reduce its capital by the VaR impact of the
trade. To evaluate whether reducing the VaR is worth it, we have to evaluate the savings made as a
result of the reduction in the capital required by the firm resulting from the trade. To do that, we need
to know the total cost to the firm of having an extra dollar of capital for the period corresponding to
the VaR measurement period. This cost includes not only the cost charged by the investors discussed
in chapter 2 but also the firms transaction costs and deadweight costs (some of these costs were
discussed in chapter 3 and further analysis of these costs is given in section 4.3.1.) associated with
Chapter 4, page 26
the use of external capital markets. Say that the total cost of capital is 14% for the firm and is
unaffected by the transaction. In this case, the net impact of the trade on the firms profits would be
$150,000 + 0.14*$571,081 = $70,049. Based on this calculation, the firm would reject the trade.
The approach developed in this section to evaluate the impact of a trade or a project on VaR
works for marginal changes. This is because the formula for the volatility impact of the trade uses the
covariances of security returns with the portfolio return. A large trade changes these covariances,
which makes the use of the formula inappropriate. This is a general difficulty with volatility and VaR
measures. These measures are not linear in the portfolio weights. In the case of VaR, this means that
the VaR of a portfolio is not the sum of the VaRs of the investments of that portfolio in individual
securities. This nonlinearity of VaR also implies that the VaR of a firm is not the sum of the VaRs of
its divisions. Therefore, one cannot simply add and subtract the VARs of the positions bought and
sold. Instead, one has to compare the VaR with the trade and the VaR without the trade to evaluate
the impact of large trades on VaR. Figure 4.3. plots the firms VaR as a function of the trade size.
This plot shows that if the firm wants to minimize its VaR, a trade much larger than the one
contemplated would be required.
Put Figure 4.3. here.
Section 4.2.2. CaR and project evaluation.
Lets now see how a firm that finds CaR to be costly should decide whether to adopt or reject
a project. To do that, we have first to understand how the project affects the firms CaR. New
projects undertaken by a firm are generally too big relative to a firms portfolio of existing projects
to be treated like small trades for a bank. Consequently, the impact of a new project on CaR cannot
Chapter 4, page 27
[ ]
1.65*Vol(C C )
Var(C ) Var(C ) 2Cov(C , C )
E N
E N E N
0.5
+
+ + 165 .
be evaluated using a measure of marginal impact like the measure of marginal impact on VaR
presented in the previous section. Instead, the impact of a new project on CaR has to be evaluated
by comparing the CaR with the project to the CaR without the project. Let C
E
be the cash flow from
the existing projects and C
N
be the cash flow from a new project being considered. Assuming that
cash flow is normally distributed, the 5% CaR without the project is given by:
1.65*Vol(C
E
)) (4.4.)
The CaR after the project is taken becomes:
(4.5.)
The impact of taking the project on CaR depends on its variance and on its covariance with existing
projects. A project with a higher variance of cash flow increases CaR more because such a project
is more likely to have large gains and large losses. Finally, a new project can have a diversification
benefit, but this benefit decreases as the covariance of the projects cash flow with the cash flow of
the other projects increases.
Lets consider now how the firm can evaluate a project when CaR has a cost. In the absence
of the cost of CaR, we already know from Chapter 2 how to evaluate a project using the CAPM. We
compute the expected cash flow from the project and discount it at the appropriate discount rate. If
CaR has a cost, we can treat the cost of CaR as another cost of the project. Hence, the NPV of the
project is decreased by the impact of the project on the cost of CaR. The cost of CaR is the cost as
of the beginning of the year resulting from the probability of having a low cash flow that prevents the
firm from taking advantage of valuable investment opportunities. This cost is therefore a present value
Chapter 4, page 28
( )
50 50 2 0 5 50 50 86 6025
2 2
0 5
+ + * . * * .
.
and should be deducted from the NPV of the project computed using the CAPM. Consequently, the
firm takes all projects whose NPV using the CAPM exceeds their impact on the cost of CaR.
Lets consider an example. We assume that cash flow is normally distributed. Suppose a firm
has expected cash flow of $80m with volatility of $50m. It now considers a project that requires an
investment of $50m with volatility of $50m. The project has a correlation coefficient of 0.5 with
existing projects. The project has a beta computed with respect to the market portfolio of 0.25. The
project has only one payoff in its lifetime and that payoff occurs at the end of the year. The expected
payoff of the project before taking into account the CAPM cost of capital for the initial investment
is $58m. We assume a riskfree rate of 4.5% and a market risk premium of 6%. Consequently, the
cost of capital of the project using the CAPM is 4.5% plus 0.25*6%. With this, the NPV of the
project using the CAPM is $58M/1.06  $50M, or $4.72M. A firm that does not care about total risk
takes this project. However, the volatility of the firms cash flow in million dollars with the project
is:
Hence, taking the project increases the volatility of the firms cash flow by $36.6025M. The CaR
before the project is 1.65*50M, or $82.5M. The CaR after the project becomes 1.65*86.6025M, or
$142.894M. A firm that ignores the cost of CaR and uses the traditional NPV analysis would take
this project. A firm for which the cost of CaR is $0.10 per dollar of CaR would reject the project
because the NPV of the project adjusted for the cost of CaR would be $4.72M minus 0.10*60.394M,
or $1.32M. More generally, a firm that assigns a cost of 8.28 cents per unit of CaR or higher would
Chapter 4, page 29
not take the project since in this case 8.28 cents times the change in CaR exceeds $5M.
If the project has cash flows over many years, it is not enough for the firm to subtract the cost
of CaR associated with the first year of the project. However, in that case, it may be difficult to
estimate the contribution of the project to the CaR of the firm in future years. To the extent that the
cost of CaR impact of the project in future years can be assessed, this impact has to be taken into
account when computing the value of the project. Each years cash flow of the project must therefore
be decreased by the impact of the project that year on the firms cost of CaR. If the impact of the
project on the cost of CaR is evaluated at the beginning of each year and takes place with certainty,
the projects contribution to the firms cost of CaR is discounted at the riskfree rate to today.
Section 4.2.3. Allocating the cost of CaR or VaR to existing activities.
A firm has to evaluate the profitability of its current activities. This way, it can decide how
to reward its managers and whether it should eliminate or expand some activities. A popular
approach to evaluating profitability is EVA, or economic value added. The idea of this approach
is straightforward. Over a period of time, an activity makes an economic profit. Computing this
economic profit can be complicated because economic profit is neither accounting profit nor cash
flow. Economic profit is the contribution of the activity to the value of the firm. Hence, it depends
on market value rather than accounting numbers. For instance, to compute economic profit we have
to take into account economic depreciation, which is the loss in value of the assets used by the
activity. In many cases, however, operating earnings of an activity are the best one can do to evaluate
its economic profits except for one crucial adjustment. When an activitys accounting profits are
computed, no adjustment is made for the opportunity cost of the capital that finances the activity.
Chapter 4, page 30
When economic profits are computed, however, we must take this opportunity cost of the capital that
finances an activity into account. To see this, suppose that a firm has two divisions, division Light and
division Heavy. Both divisions have accounting profits of $20m. Based on accounting profits, the
CEO should be pleased. Yet, the key insight of EVA is that a firm might make accounting profits
but decrease shareholder wealth. This is because the accounting profits do not take into account the
opportunity cost of the capital used by the two divisions. Suppose that division Light uses $100M
of firm capital. For instance, it could have plants and working capital that are worth $100M. Suppose
that we assess a capital charge equal to the cost of capital of the firm of 10%. This means that the
firm could expect to earn 10% on the capital used by the division Light if it could invest it at the
firms cost of capital. The opportunity cost of the capital used by the division Light is therefore
$10M. Economic profits of division Light are $20M minus $10M, or $10M. Lets now look at
division Heavy. This division has $1B of capital. Hence, the opportunity cost of this capital using the
firms cost of capital is $100M. Consequently, this division makes an economic loss of $80M, or
$20M minus $100M. A division that makes an economic profit before taking into account the
opportunity cost of capital can therefore make a loss after taking this cost into account.
The computation of economic profit that assigns a capital charge based on the assets of a
division is based on the capital budgeting tools derived in chapter 2. It ignores the fact that any
activity of the firm contributes to the risk of the firm. If the firm finds CaR to be costly, the
contribution of an activity to the cost of CaR is a cost of that activity like any other cost. An activity
might use no capital in the conventional sense, yet it might increase the firms CaR or VaR. If the firm
can access capital markets, one can think of that cost as the cost of the capital required to offset the
impact of the activity on the firms CaR or VaR. This capital is often called the risk capital. When one
Chapter 4, page 31
evaluates the profitability of an activity, one has to take into account not only the capital used to run
the activity but also the capital required to support the risk of the activity.
Consider a firm where CaR has a cost that the firm can estimate for the firm as a whole. This
means that the activities of the firm together have this cost of CaR. When evaluating a specific
activity, the firm has to decide how much of the cost of CaR it should assign to this activity. For the
firm to do this, it has to allocate a fraction of CaR to each activity. Lets assume that the firm has N
activities. These activities could be divisions. Allocating 1/N of CaR to each activity would make no
sense because some activities may be riskless and others may have considerable risk. The firm
therefore has to find a way to allocate CaR to each activity that takes into account the risk of the
activity and how it contributes to firm risk. We have seen repeatedly that the contribution of a
security to the risk of a portfolio is measured by the covariance of its return with the return of the
portfolio or by the beta of the return of that security with the return of the portfolio. Using this insight
of modern portfolio theory, we can measure the contribution of the risk of an activity to the firms
CaR by the cash flow beta of the activity. An activitys cash flow beta is the covariance of the cash
flow of the activity with the cash flow of the firm divided by the variance of the cash flow of the firm.
Lets see how using cash flow betas allows the firm to allocate CaR to the various activities.
The cash flow of the ith activity is C
i
. The firms total cash flow is the sum of the cash flows of the
activities, which we write C. We assume that the cash flows are normally distributed. Consequently,
the CaR of this firm is 1.65Vol(C). Remember that the variance of a random variable is the covariance
of the random variable with itself, so that Var(C
i
) is equal to Cov(C
i
,C
i
). Further, covariances of cash
flows of the various activities with the cash flow of activity i can be added up so that the sum of the
Chapter 4, page 32
Firm cash flow variance = Var(C)
= Cov(C C
Cov(C C
Cov(C Firm cash flow C)
i j
j=1
N
i=1
N
i j
j=1
N
i=1
N
i
i=1
N
, )
, )
,
i
i=1
i
i=1
N
Cov(C C) Var(C)
= Var(C) / Var(C)
= 1
N
, /
covariances is equal to the covariance of the cash flow of activity i with the firms cash flow, Cov(C
i
,
C). The variance of the firm cash flow is therefore the sum of the covariances of the cash flow of the
activities with the cash flow of the firm:
(4.6.)
Equation (4.6.) shows that the variance of firm cash flow can be split into the covariance of the cash
flow of each activity with the firms cash flow. Increasing the covariance of the cash flow of an
activity with the firms cash flow increases the variance of the firms cash flow. If we divide
Cov(C
i
,C) by Var(C), we have the cash flow beta of activity i with respect to firm cash flow, $
i
. The
cash flow betas of the firms activities sum to one since adding the numerator of the cash flow betas
across activities gives us the variance of cash flow which is the denominator of each cash flow beta:
(4.7.)
Because the cash flow betas sum to one, they allow us to decompose CaR into N components, one
for each activity. The firms CaR is then equal to 1.65 times the sum of the cash flow betas times the
volatility of cash flow:
Chapter 4, page 33
Firm CaR = 1.65Vol(C)
= 1.65Var(C) / Vol(C)
= 1.65 Cov(C C Vol(C)
=
Cov(C , C)
Var(C)
1.65Var(C) Vol(C)
= CaR
i
i=1
N
i
i=1
N
i
i=1
, ) /
/
_
,
N (4.8.)
This decomposition attributes a greater fraction of CaR to those activities that contribute more to the
volatility or the variance of firm cash flow. Consequently, the cash flow beta of the ith activity is the
fraction of the firms CaR that we can attribute to project i:
Contribution of activity to CaR
The fraction of CaR that is due to activity i is equal to the beta of activity i with respect to firm cash
flow, $
i
=Cov(C
i
,C)/Var(C).
Consequently, the contribution of activity i to the cost of CaR is equal to the cash flow beta of the
activity times the firms cost of CaR.
Lets consider an example. A firm has a CaR of $100M. An activity has an expected cash flow
of $12M. The beta of the cash flow is 0.5. The activity uses $40M of capital before taking into
account the CaR. The cost of capital is 10% p.a. In this case, the expected economic profit of the
Chapter 4, page 34
activity before taking into account CaR is $12M minus 10% of $40M, which amounts to $8M. The
project therefore has a positive expected economic profit before taking into account CaR. The
contribution of the activity to the risk of the firm is 0.5*$100M, or $50M. If the cost of CaR is $0.20
per dollar, the activity contributes $10M to the firms cost of CaR. As a result, the project is not
profitable after taking into account the cost of CaR.
Consider next a firm that uses VaR. Such a firm will want to evaluate the performance of
positions or activities. It must therefore be able to allocate VaR across these positions or activities.
Remember that with VaR, we use the distribution of the change in the value of the portfolio or firm
instead of the distribution of cash flow. However, if changes in value are normally distributed, the
analysis we performed for CaR applies to VaR. The change in value of the portfolio is the sum of the
changes in value of the positions in the portfolio. The variance of the change in the value of the
portfolio is equal to the sum of the covariances of the changes in the value of the positions with the
change in the value of the portfolio. Consequently, we can compute the beta of a position with
respect to the portfolio, namely the covariance of the change in value of the position with the change
in value of the portfolio divided by the variance of the change in value of the portfolio. This position
beta measures the contribution of the position to the VaR.
When considering VaR examples, we assumed that returns instead of dollar changes were
normally distributed. Lets see how we can decompose VaR in this case among N positions. The
investment in position i is the portfolio share of the position times the value of the portfolio, w
i
W. The
return of the position is R
i
. Consequently, the change in value due to position i is w
i
R
i
W. Let R
m
be
the return of the portfolio. In this case, the variance of the dollar change in the portfolio can be
written as:
Chapter 4, page 35
( )
Variance of change in portfolio value
= Cov(w R W, R W)
= w Cov(R R W
w Cov(R R Var(R Var(R W
Var(Change in portfolio value)
i i m
i=1
N
i i m
2
i=1
N
i i m m m
2
i=1
N
i=1
N
, )
, ) / ) )
w
i im
(4.9.)
Consequently, the contribution of a position to the variance of the change in portfolio value is the
portfolio share of the position times the beta of the return of the position with respect to the return
of the portfolio. Using the same reasoning as with CaR, it follows that:
Contribution of position to VaR
The fraction of VaR that is due to position i is the portfolio share of that position times the beta of
its return with respect to the return of the portfolio.
Lets look at an example. Suppose that a firm has 50% of its portfolio invested in a stock
whose return has a beta of 3 with respect to the portfolio. In this case, the portfolio share is 0.5 and
the fraction of VaR contributed by the position is 3*0.5, or 1.5. This means that 150% of the cost of
VaR should be charged to the position. If a position contributes more than 100% of VaR, it means
that the other positions reduce risk. Hence, contributions to VaR can exceed 100% or can be
negative. Consider now a firm where VaR has a cost of $10M per year. For the ith position to be
worthwhile, it must be that its expected gain exceeds $15M, which is its contribution to the cost of
Chapter 4, page 36
VaR.
Rather than thinking of a position in a portfolio, however, we could think of an investment
bank where a trading post contributes to the VaR of the bank. Suppose that at the end of the year the
capital used by the trader has increased. The trader had $50M at the start of the year and has $75M
at the end of the year, so that he earned $25M. To find out whether the trading was profitable, we
have to take into account the opportunity cost of $50M. Say that the firms cost of capital is 15% and
that this is a reasonable measure of the opportunity cost of $50M. After this capital allocation, the
trader has a profit of only $17.5M, or $25M minus 15% of $50M. This capital allocation does not
take into account the impact of the traders activity on the VaR of the firm and its cost. Suppose that
the VaR of the firm is $2B and that the beta of the return of the trader with the return of the firm is
1. The firms value at the beginning of the year is $1B. The portfolio share of the trader is therefore
$50M/$1B, or 0.05. The trader also contributes 5% of VaR. Lets now assume that the cost of VaR
is $100m. In this case, the trader contributes $5M of the cost of VaR. His contribution to the
economic profits of the firm is therefore $17.5M minus $5M, or $12.5M.
Firms that evaluate economic profits taking into account the contribution of activities to the
risk of the firm do so in a number of different ways and give different names to the procedure. One
approach that is often used, however, is called RAROC among financial institutions. It stands for risk
adjusted return on capital. Box 4.2. RAROC at Bank of America discusses the application of that
approach at one financial institution.
Put Box 4.2. here
Section 4.3. Managing firm risk measured by VaR or CaR.
Firm risk as measured by VaR or CaR is costly. Consequently, the firm can increase its value
Chapter 4, page 37
if it succeeds in reducing its cost of risk. A firm can do so in two ways. First, it can reduce risk. This
amounts to reducing VaR or CaR. Second, it can reduce the cost of risk for a given level of CaR or
VaR. The firm has numerous tools available to change the cost of risk. The simplest way to reduce
risk is to sell the firms projects and put the proceeds in Tbills. To the extent that the projects are
more valuable within the firm than outside the firm, this approach to risk reduction is extremely
costly. Hence, the firm has to find ways to manage the cost of risk so that firm value is maximized.
Three approaches represent the firms main options to manage the cost of risk: increase capital, select
projects according to their impact on firmwide risk, use derivatives and other financial instruments
to hedge. We discuss these approaches in turn.
Section 4.3.1. Increase capital.
Consider first a financial institution. This institution is concerned that a fall in value will
increase its credit risk and lead to an exodus of its customers. The institutions credit risk is inversely
related to its equity capital since equity capital provides funds that can be used to compensate
customers in the event that the firms traded assets lose value. The same reasoning applies for a
nonfinancial corporation that focuses on CaR. The corporation is concerned about its CaR because
a bad cash flow outcome means that the firm cannot invest as much as would be profitable. If the firm
raises more capital, it can use it to create a cash reserve or to decrease debt. In either case, the firms
ability to pursue its investment plan increases with its equity capital.
If capital has no opportunity cost, there is no reason for a firm to be concerned about its CaR
or VaR risk. In this case, the firm can simply increase its capital up to the point where a bad outcome
in cash flow or in the value of its securities has no impact on credit risk. Lets make sure that we
Chapter 4, page 38
understand how increasing the firms equity impacts CaR and its cost. Remember that CaR measures
a dollar shortfall. If the firm raises equity and uses it to just expand the scale of its activities, CaR
increases because the cash flow of the firm after the equity issue is just a multiple of the firms cash
flow before the equity issue. To issue equity in a way that reduces the firms risk, the proceeds of
the equity issue have to be invested in projects that have negative cash flow betas. Investing the
proceeds of the equity issue in riskfree investments or using them to pay back debt with fixed debt
service does not change the firms CaR. Remember that a projects contribution to CaR is its cash
flow beta. If debt payments and interest earned on the riskfree asset are nonstochastic, they have
a cash flow beta of zero and therefore do not increase or decrease CaR. However, investing the
proceeds in the riskfree asset or using them to reduce the firms debt reduces the cost of CaR. As
the firm builds up slack, a bad cash flow outcome has less of an impact on investment because the
firm can use its slack to offset the cash flow shortfall. Hence, an equity issue reduces the cost of CaR
by enabling the firm to cope more easily with a cash flow shortfall. One might argue that the firm does
not have to raise equity now to cope with a cash flow shortfall that might occur in the future. This
would be correct if the firm faces the same cost of raising equity after the cash flow shortfall has
occurred than before. In general, this will not be the case. After a cash flow shortfall has occurred,
outsiders have trouble figuring out whether the cash flow shortfall occurred because of bad luck,
because of managerial incompetence, or because of management pursuing objectives other than the
maximization of shareholder wealth. As a result, equity capital will tend to be most expensive or even
impossible to obtain precisely when obtaining it has most value for the firm.
As a firm raises equity to reduce its cost of CaR, it must keep its operations unchanged and
use the proceeds to pay back debt, which reduces debt service, or to invest in riskfree assets.
Chapter 4, page 39
Consider now the firm that issues equity and buys back debt. The equity holders expect a return on
their equity commensurate with the risk of equity. By issuing equity to buy back debt, the firm makes
the remaining debt less risky and generally gives a windfall to existing debtholders whose debt is
bought back by making it unexpectedly riskfree. Hence, shareholders do not capture the whole
benefit of increasing the firms equity capital. Some of that benefit is captured by the debtholders.
Further, shareholders lose the tax shield on the debt bought back and replaced by equity. As a result,
issuing equity to reduce the cost of CaR has costs for the shareholders. The costs of equity are
increased further by the fact that management can do anything with this money that it wants unless
the firm becomes bankrupt or is taken over. Hence, management must convince equity holders that
it will invest the new money profitably. Doing so is difficult for management because of information
asymmetries and because of agency costs.
Management generally benefits from having more resources under its control. With more
assets, the firm is less likely to become bankrupt and management has more perks and is paid more.
Hence, if management could raise equity easily, it would keep doing so. The problem is that since
management benefits from having more resources under its control, it wants to raise equity even when
it does not have good uses for the new funds. The possibility that the projects the firm has might not
be as good as management claims reduces the proceeds from new equity issues. By lowering the price
they are willing to pay for shares, investors make it more likely that they will receive a fair return.
This makes new equity expensive. In fact, new equity can be so expensive that a firm with valuable
new projects to finance may decide not to issue equity and give up its investment opportunities.
Having enough equity to make risk management irrelevant is generally not an option.
Financial economists have provided measures of the cost of raising equity capital. First, there
Chapter 4, page 40
is a transaction cost. Investment bankers have to be paid. This cost can be of the order of 5% of the
value of the new equity. Second, there is a stockprice impact. When a firm announces an equity
issue, the value of its existing equity falls by about 2.5%. There is some debate as to whether some
or all of this fall in the equity price represents a cost of issuing equity or is just the result that the
market learns about the true value of the firm when it issues equity, information that the market
would have learned anyway. This fall, however, means that if a firm with one billion dollars worth of
equity sells $100m of new equity, its net resources increase by about $75m. In other words, the
increase in net resources associated with an equity issue is only a fraction of the equity raised. This
evidence is only for firms that issue equity. It does not include firms that give up profitable projects
instead of issuing equity. That firms give up valuable projects instead of issuing equity is documented
by a literature that shows the impact of firm liquidity on investment. This literature shows that firms
with fewer liquid assets typically invest less controlling for the value of the investment opportunities.
In other words, if two firms have equally valuable investment opportunities, the one with fewer liquid
assets invests less.
Section 4.3.2. Project choice.
When firm risk is costly, the firm can choose projects so that its risk is low. This means that
the firm gives up projects with high profits if these projects increase firm risk substantially and that
it chooses poor projects because they might reduce firm risk. This approach of dealing with risk is
quite expensive. It means that the firm avoids investing in projects that might have high payoffs simply
because they contribute to firm risk. It also means that it tailors its strategy so that it invests in
activities not because they are the most profitable but because they have a favorable impact on firm
Chapter 4, page 41
risk.
Traditionally, firms have viewed diversification across activities as a way to manage their risk.
By investing in a project whose return is imperfectly correlated with existing projects instead of
investing in a project whose return is perfectly correlated with them, the firm increases risk less. It
could be, however, that the project with greater diversification benefits has lower expected profits.
In fact, a firm might prefer a project that has a negative NPV using the CAPM to a project with a
positive NPV if the project with the negative NPV decreases firm risk. The problem with managing
the firms risk this way is that it is also very expensive. The reason for this is that managing projects
that are not closely related is costly. A firm that has firmspecific capital that gives it a comparative
advantage to develop some types of projects does not have that comparative advantage for
diversifying projects. Diversifying projects require another layer of management.
Empirical evidence demonstrates that typically the costs of diversification within firms are
high. The simplest way to evaluate these costs is to compare a diversified firm to a portfolio of
specialized firms whose assets match the assets of the diversified firm. The empirical evidence
indicates that the portfolio is on average worth about 14% more than the diversified firm. This
empirical evidence therefore documents a diversification discount, in that a diversified firm is worth
less than a matching portfolio of specialized firms.
Section 4.3.1.C. Derivatives and financing transactions.
We saw that firms could reduce their cost of risk by increasing their equity or by choosing
projects that reduce risk. Both of these solutions to managing firm risk involve substantial costs. In
general, one would expect that firms could reduce their risk through the use of financial instruments
Chapter 4, page 42
at less cost. The reason is that transaction costs associated with trades in financial instruments are
generally small. They are measured in basis points or pennies per dollar. In the most liquid markets,
such as the spot foreign exchange market, they are even smaller than that. By using financial
instruments to manage risk, the firm therefore achieves two outcomes. First, it reduces its risk, which
means that it increases its value. Second, when the firm contemplates a new project, it can structure
the new project so that its hedged risk is minimized. This means that the relevant measure of the
projects contribution to firmwide risk is its contribution net of hedging activities. It is perfectly
possible for an unhedged project to contribute too much to the risk of the firm to be worthwhile, but
once the project is hedged, it becomes a worthwhile project that the firm can take profitably.
Using financial instruments to reduce risk can therefore allow a firm to grow more and to be
worth more. The firm can use existing financial instruments or new ones. As the firm uses financial
instruments, however, the risk of these instruments has to be taken into account when measuring the
firms risk. This is feasible when the firm uses VaR since then the financial instruments that the firm
uses become part of its portfolio.
Taking into account the risk of financial instruments is more difficult if the firm uses CaR as
a risk measure. The reason for this is that the firm should monitor the value of its position in financial
instruments frequently and the risk of financial instruments is best measured with a VaR measure.
Hence, a firm could compute a VaR for the financial instruments it has taken positions in. Existing
SEC rules on the reporting of derivatives in fact encourage firms to report such a VaR measure. The
problem with such a measure, though, is that it is easy to misinterpret. Consider a firm that has
important risks that are hedged with financial instruments. The portfolio of financial instruments is
risky as a standalone portfolio. However, since the portfolio is a hedge, firm risk is less with the
Chapter 4, page 43
portfolio than without. The standalone risk of the portfolio of financial instruments is therefore not
instructive about the contribution of these financial instruments to the risk of the firm.
Section 4.3.3. The limits of risk management.
There are several reasons why firms cannot eliminate all risks and may not find it profitable
to eliminate some risks they could eliminate. It only makes sense to get rid of risks if doing so
increases firm value. This means that risks that have little impact on firm value but are expensive to
eliminate are kept. There are three key limits to risk management:
1. It is not rocket science. Financial engineering, derivatives and parts of risk management
are often viewed as the domain of rocket scientists. It is perfectly true that there are many
opportunities for scientists from the hard sciences to make major contributions in financial
engineering and risk management. At the same time, however, finance is part of the social sciences.
This means that there are no immutable laws such that every action always leads to the same
outcome. Markets are made of people. The way people react can change rapidly. Hence, models used
for risk management are always imperfect, between the time they were devised and the time they are
used, things have changed. A keen awareness of this intrinsic limitation of risk management is crucial.
This means that all the time we must seek to understand where the models we use have flaws. We
can never stop from asking What if... The risk measures we have developed are tremendously
useful, but no risk manager can ever be sure that he is taking into account all factors that affect the
risk of the firm and that he is doing so correctly. Even if he did everything perfectly when he
estimated the firms risk, the world may have changed since he did it.
2. Credit risks. For the firm to be able to receive payments in bad times, it must either make
Chapter 4, page 44
payments now or be in a position to make offsetting payments in good times. If there are no
information asymmetries about the financial position of the firm, the firm will be able to enter
contracts that achieve its risk management objectives. However, counterparties may be uncertain
about the firms ability to pay off in good times or even about what good times are for the firm. In
this case, counterparties will require collateral or will only agree to prices that are unfavorable to the
firm. The firm may find it too expensive to trade at the prices it can trade at.
Lets look at an example. Suppose that the firm is an exporter to Germany. For constant sales,
the exporter receives more dollars as the dollar price of the Euro increases. If the exporter has
constant Euro sales, selling Euros forward eliminates all income risk. Hence, if this is the only risk
the firm faces, it should be easy for it to eliminate risk. However, the firm may have other risks. For
instance, it could be that sales in Euros are uncertain, so that in some situations the company might
not have enough Euros to deliver to settle the forward contract and has to default. If outsiders are
uncertain about the risks the firm has, they may only be willing to transact at a forward price that is
highly unfavorable to the firm given managements information about the firms risks. In this case,
the firm may choose not to hedge unless management can convince outsiders about the nature of the
risks the firm faces. Alternatively, the firm may choose not to export to Germany if the unhedged
risks are too high.
3. Moral hazard. Lets go back to the above example. Suppose now that the sales in
Germany depend on the efforts of management. Management sells a given quantity of Euros forward,
but to obtain that quantity of Euros, management will have to work hard. Whether management
works hard or not cannot be observed by outsiders, however. If management sold Euros forward and
the Euro appreciates, management may choose to work less hard because it does not get as much
Chapter 4, page 45
benefit from working hard as it would have if it had not sold the Euros forward. This is because the
Euros it gets are delivered to settle the forward contract at a lower price than the spot price. Hence,
management might be tempted not to work when the Euro appreciates and to work hard when it
depreciates since then it gets to sell the Euros at a higher price than the spot price. The fact that
management can take actions that affect the value of contracts adversely for the counterparty creates
what is called moral hazard. Moral hazard is the risk resulting from the ability of a party to a
contract to take unobserved actions that adversely affect the value of the contract for the other party.
The existence of moral hazard may make it impossible for the firm to take the forward position it
wants to. This is because the counterparty expects the firm to default if the Euro appreciates because
management does not work hard. Even if management wanted to work hard in that case, it may not
be able to convince the counterparty that it would do so because it would always benefit from
convincing the counterparty that it will work hard and then not doing so.
There is one aspect of the moral hazard problem that we want to stress here. Remember from
the discussion in the previous chapter that the firm can sell debt at a higher price if the buyers believe
that the firm will reduce its risk. Hence, it is tempting for management to promise to reduce risk and
then forget about its promise. However, if the firms creditors expect management to behave this
way, they buy debt at a low price. It is therefore important for the firm to be able to commit credibly
to a policy of risk management. For instance, it may want to write in the bond indenture provisions
about the risks it will eliminate and how, so that if it does not follow through with its risk
management promises, it will be in default. Interestingly, debt in leveraged buyouts, where firms
typically have extremely high leverage often, has covenants specifying that the firm has to manage
some risks, for instance interest rate risks.
Chapter 4, page 46
As we learn more about risk management and financial engineering, we will also learn more
about how to cope and extend the limits of risk management.
Section 4.4. An integrated approach to risk management.
In chapter 3, we showed how firms can benefit from risk management. In this chapter, we
showed how the analysis of chapter 3 implies that firms will want to manage specific risk measures.
We therefore introduced VaR and CaR. Estimating a firms risk is the starting point of using risk
management to increase firm value. Once a firms risk is estimated, it has to figure out the cost of
bearing this risk and assess how best to bear the optimal amount of risk. We argued that when
evaluating new projects, firms have to evaluate their impact on the cost of bearing risk. We then
showed that a firm has a number of tools available to manage firm risk. Firms can increase their equity
capital, take projects that are less risky, take projects that decrease firmwide risk, or use financial
instruments to hedge risks. Derivatives often provide the most efficient tools to manage firm risk. The
reason for this is that this tool is often cheap and flexible. Derivatives can be designed to create a
wide range of cash flows and their transaction costs are generally extremely low compared to the
costs of using other risk management tools.
Chapter 4, page 47
Literature note
For an analysis of risk management in financial institutions and the role of risk capital, see
Merton (1993) and Merton and Perold (1993). VaR is presented in the Riskmetrics technical manual
and in Jorion (). EVA is presented extensively in Stewart (). For a discussion of RAROC, see
Zaik, Walter, Kelling, and James (1996). Litterman () discusses the marginal VaR and plots VaR as
a function of trade size. Matten (1996) provides a booklength treatment of the issues related to
capital allocation. Saita (1999) discussed a number of organizational issues related to capital
allocation. Froot and Stein (1998) provide a theoretical model where they derive optimal hedges and
capital budgeting rules. Stoughton and Zechner (1998) extend such an approach to take into account
information asymmetries. The internal models approach for regulatory capital is presented in
Hendricks and Hirtle (1997). Santomero (1995) provides an analysis of the risk management process
in commercial banks.
Smith (1986) reviews the literature on the stockprice impact of selling securities. Myers and
Majluf (1984) discuss the case where a firm does not issue equity because doing so is too expensive.
Stulz (1990) examines the implications of the agency costs of managerial discretion on the firms cost
of external finance. Fazzari, Hubbard, and Petersen (1988) provide a seminal analysis of how
investment is related to liquidity. Opler, Pinkowitz, Stulz and Williamson (1999) show how
investment is related to slack. Lang and Stulz (1995) and Berger and Ofek (1996) discuss the costs
of diversification.
Chapter 4, page 48
Key concepts
VaR, CaR, VaR, VaR impact of trade, CaR impact of project, cash flow beta, contribution of activity
to CaR, contribution of position to VaR.
Chapter 4, page 49
Review questions
1. Why do firms require a risk measure?
2. What is VaR?
3. How does VaR differ from variance?
4. How is the VaR of a portfolio computed if returns on assets are normally distributed?
5. Why is VaR an appropriate risk measure for financial institutions?
6. What is CaR?
7. When would a firm use CaR?
8. How do you choose a project if VaR is costly?
9. How do you choose a project if CaR is costly?
10. How do you measure a divisions contribution to the firms CaR?
11. Should the contribution of a division to the firms CaR affect the firms estimate of its
profitability?
12. Why and how should you use VaR to evaluate the profitability of a trader?
13. How can the firm reduce CaR or VaR?
14. How can the firm reduce its cost of CaR or VaR for given levels of CaR or VaR?
15. How does moral hazard limit the ability of a firm to manage its risk?
Chapter 4, page 50
Problems
1. Consider a firm with a trading book valued at $100M. The return of these assets is distributed
normally with a yearly standard deviation of 25%. The firm can liquidate all of the assets within an
hour in liquid markets. How much capital should the firm have so that 99 days out of 100, the firms
return on assets is high enough that it does not exhaust its capital?
2. Consider the firm of question 1. Now the firm is in a situation where it cannot liquidate its portfolio
for five days. How much capital does it need to have so that 95 fiveday periods out of 100, its capital
supports its trading activities ignoring the expected return of the firms trading book?
3. How does your answer to question 2 change if the firms trading book has an annual expected
return of 10%?
4. A firm has a trading book composed of two assets with normally distributed returns. The first
asset has an annual expected return of 10% and an annual volatility of 25%. The firm has a position
of $100M in that asset. The second asset has an annual expected return of 20% and an annual
volatility 20% as well. The firm has a position of $50m in that asset. The correlation coefficient
between the return of these two assets is 0.2. Compute the 5% annual VaR for that firms trading
book.
5. Consider a firm with a portfolio of traded assets worth $100M with a VaR of $20M. This firm
considers selling a position worth $1m to purchase a position with same value in a different asset. The
Chapter 4, page 51
covariance of the return of the position to be sold with the return of the portfolio is 0.05. The asset
it acquires is uncorrelated with the portfolio. By how much does the VaR change with this trade?
Hint: Remember how to go from return VaR to dollar VaR.
6. Going back to question 4, consider a trade for this firm where it sells $10m of the first asset and
buys $10m of the second asset. By how much does the 5% VaR change?
7. A firm has a yearly cash flow at risk of $200M. Its cost of capital is 12%. The firm can expand the
scale of its activities by 10%. It wants to increase its capital to support the new activities. How much
capital does it have to raise? How much must the project earn before taking into account the capital
required to protect it against losses to be profitable?
8. Consider the choice of two mutually exclusive projects by a firm. The first project is a scale
expanding project. By investing $100M the firm expects to earn $20M a year before any capital
charges. The project is infinitely lived, so that there is no depreciation. This project also increases
cash flow at risk by $50M. The second project requires no initial investment and is expected to earn
$25M. This project increases the cash flow at risk by $200M. Which project has the higher expected
economic profit in dollars?
9. The treasurer of a firm tells you that he just computed a oneyear VaR and a oneyear CaR for his
firm. He is puzzled because both numbers are the same. How could that be the case?
Chapter 4, page 52
10. You sit on the board of corporation and you believe that management hedges too much. You
want to make sure that management hedges so as to maximize the value of the firm only. You do not
know which hedges will achieve that outcome. What are the options available to you to make the
desired outcome more likely given the empirical evidence?
Chapter 4, page 53
Probability
Return in
percent
33%
0.05
10%
0.16
Figure 4.1. Using the cumulative distribution function.
The figure graphs the cumulative distribution function of a normally distributed return with expected
value of 10% and volatility of 20%. From this graph, the probability of a loss of 33% or greater is
0.05.
Chapter 4, page 54
D i st r i b u t i o n fo r p o r t f o l i o v a l u e s
4
6
.
6
8
1
.
5
1
1
7
1
5
3
1
8
9
2
2
4
2
6
0
2
9
6
3
3
2
3
6
7
4
0
3
P o r t f o l i o v a l u e s
P
r
o
b
a
b
i
l
i
t
y
Figure 4.2. Frequency distribution of two portfolios over one year horizon.
The stock portfolio is invested in a stock that has an expected return of 15% and a volatility of return
of 20% over the measurement period. The other portfolio has 1.57 calls on the stock with exercise
price of $100M that cost $23.11M and the rest invested in the riskfree asset earning 6%.
Chapter 4, page 55
Figure 4.3. VaR as a function of trade size.
This figure graphs the VaR as a function of trade size for the example used in the text.
Chapter 4, page 56
Required capital for day t +1 = Max VaR S VaR (1%,10) + SR
t t ti
i 1
59
t
( ); * 1%,10
1
60
1
]
1
Box 4.1. VaR, banks, and regulators
The U.S. regulatory agencies adopted the market risk amendment to the 1988 Basle Capital Accord
(which regulates capital requirements for banks to cover credit risk) in August 1996. This amendment
became effect in January 1998. It requires banks with significant trading activities to set aside capital
to cover market risk exposure in their trading accounts.
The central component of the regulation is a VaR calculation.The VaR is computed at the 1% level
for a 10day (two weeks) holding period using the banks own model. The capital the firm must set
aside depends on this VaR in the following way. Let VaR
t
(1%,10) be the VaR of the trading accounts
computed at the 1% level for a ten day trading period at date t. The amount of capital the bank has
to hold for the market risk of its trading accounts is given by:
where S
t
is a multiplier and SR
t
is an additional charge for idiosyncratic risk. The terms in square
brackets are the current VaR estimate and an average of the VaR estimate over the last 60 days. The
multiplier S
t
depends on the accuracy of the banks VaR model. The multiplier uses the banks VaR
for a oneday period at the 1% level over the last 250 days. If the bank exceeds its daily VaR 4 times
or less, it is in the green zone and the multiplier is set at 3. If the bank exceeds its daily VaR 5 to 9
times, it is in the yellow zone and the multiplier increases with the number of cases where it exceeds
the VaR. If the bank exceeds its daily VaR 10 times or not, its VaR model is deemed inaccurate and
the multiplier takes a value of 4. Hence, by having a better VaR model, the bank saves on regulatory
capital.
Banks routinely provide information on their VaR for trading accounts in their annual reports. They
did so even before the market risk amendment. In 1996, JP Morgan reported an average oneday VaR
at the 5% level of $21M. In contrast, Bankers Trust reported an average oneday VaR of $39M at
the 1% level.
Chapter 4, page 57
RAROC of business unit '
Economic profit of unit & Capital allocated(Hurdle rate
Capital allocated
Box 4.2. RAROC at Bank of America
In November 1993, a Risk and Capital Analysis Department was formed at Bank of America and
charged with developing a framework for riskadjusted profitability measurement. The requirement
was that the system would be operational within four months. The bank decided to measure risk over
a oneyear horizon. Four risks were identified, namely credit risk, country risk, market risk, and
business risk. Credit risk is the risk of borrower default. Country risk is the risk of loss in foreign
exposures arising from government actions. Market risk is the risk associated with changes in market
prices of traded assets. Finally, business risk corresponds to operational risk associated with business
units as ongoing concerns after excluding the other three risks. For each of these risks, the bank is
concerned about unexpected risk and how it will affect its own credit rating. For instance, it regularly
makes provisions for credit losses. Consequently, normal credit losses do not affect earnings but
unexpected credit losses do.
Bank of America decided to have an amount of capital such that the risk of default is 0.03% per year,
which guarantees an AA rating. It concluded that to ensure a probability of default no greater than
0.03% across its various businesses, it had to allocate capital of 3.4 standard deviations to market
risks and 6 standard deviations to credit risks. The reason it allocates different amount of capital to
different risks is that it views market risks as being normally distributed whereas credit risks are not.
All capital allocated is charged the same hurdle rate, which is the corporatewide cost of equity
capital. A project is evaluated based on its economic profit, calculated as earnings net of taxes,
interest payments, and expected credit losses. The capital required for the project is then determined
based on the credit risk, market risk, country risk, and business risk of the project. The riskadjusted
expected economic profit is then the expected economic profit minus the hurdle rate times the
allocated capital.
Bank of America applies the above approach to evaluate its business units. For each business unit,
it computes its RAROC as follows:
Source: Christoper James, RAROC based capital budgeting and performance evaluation: A case study
of bank capital allocation, working paper 9640, Wharton Financial Institutions Center, The Wharton
School, Philadelphia, PA.
Chapter 4, page 58
w Var(R ) w w Cov(R , R ) Var(R
i
2
i i j i j
j i
N
i 1
N N
p
+
i 1
)
2w Var(R ) w + 2 w Cov(R , R ) w = Impact of trade w on Var(R )
i i j i j
j i
N
p
, ) / )
)
ip
Technical Box 4.1. Impact of trade on volatility.
Remember the definition of the variance of the portfolio return given in equation (2.3.):
Taking the derivative of the formula for the variance with respect to w
i
, the impact of an increase in
the portfolio share of security i of )w on the variance is:
The volatility is the square root of the variance. Consequently, taking the derivative of volatility with
respect to the variance, a change in the variance of )Var(R
p
) changes the volatility by
0.5*)Var(R
p
)*[Var(R
p
)]
0.5
= 0.5*)Var(R
p
)/Vol(R
p
). We substitute in this expression the change in
the variance brought about by the increase in the holding of security i to get the impact on portfolio
return volatility:
Equation (4.1.) follows from computing the impact of increasing the portfolio share of security i by
Chapter 4, page 59
)w and decreasing the portfolio share of security j by the same amount.
Chapter 5: Forward and futures contracts
Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Section 5.1. Pricing forward contracts on Tbills. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Section 5.1.A.Valuing a forward position at inception using the method of pricing
by arbitrage. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Section 5.1.B. A general pricing formula . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10
Section 5.1.C. Pricing the contract after inception . . . . . . . . . . . . . . . . . . . . . . . 11
Section 5.2. Generalizing our results. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13
Section 5.2.A. Foreign currency forward contracts. . . . . . . . . . . . . . . . . . . . . . 17
Section 5.2.B. Commodity forward contracts . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Section 5.3. Futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Section 5.3.A. How futures contracts differ from forward contracts . . . . . . . . . 25
Section 5.3.B. A brief history of financial futures . . . . . . . . . . . . . . . . . . . . . . . 29
Section 5.3.C. Cash versus physical delivery. . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Section 5.3.D. Futures positions in practice: The case of the SFR futures contract
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32
Section 5.4. How to lose money with futures and forward contracts without meaning to.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Section 5.4.A. Pricing futures contracts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Section 5.4.B. The relation between the expected future spot price and the price
for future delivery . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38
Section 5.4.C. What if the forward price does not equal the theoretical forward
price? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39
Section 5.5. Conclusion. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
Literature Note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Table 5.1. Arbitrage trade when F = $0.99 per dollar of face value . . . . . . . . . . . . . . . . 51
Table 5.2. Long SFR futures position during March 1999 in the June 1999 contract . . . 52
Exhibit 5.1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Figure 5.1. Timeline for long forward contract position . . . . . . . . . . . . . . . . . . . . . . . . 54
Figure 5.2. Difference between the forward price and the spot price of the underlying
good . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Figure 5.3. Margin account balance and margin deposits . . . . . . . . . . . . . . . . . . . . . . . 56
Figure 5.4. Daily gains and losses from a long futures position in the SFR in March 1999
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Figure 5.5. Marking to market and hedging.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58
Box 5.1. Repos and borrowing using Treasury securities as collateral . . . . . . . . . . . . . . 59
Box 5.2. Interest rate parity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
Box 5.2. Figure. Term structures in the home and foreign country used to obtain the term
structure of forward premia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Box 5.3. The cheapest to deliver bond and the case of Fenwick Capital Management . . 63
Ch. 1 Pg. 1
Chapter 5: Forward and futures contracts
December 3, 1999
Ren M. Stulz 1998, 1999
Ch. 1 Pg. 1
Chapter objectives
1. Explain how forward contracts are priced.
2. Describe how futures contracts differ from forward contracts.
3. Analyze the determinants of the price of futures contracts.
Chapter 5, page 1
We now understand that risk management can be used to increase firm value and the welfare
of investors. In the remainder of this book, we show how to do it. Much of our focus is on how to
use existing derivatives and create new ones to increase firm value through risk management.
However, we also discuss how to use derivatives in portfolio strategies. There are too many different
types of derivatives for us to provide a complete catalogue of their properties and uses. Instead, we
will learn how to understand and use derivatives in general.
We start in this chapter with the simplest kinds of derivatives, forward and futures contracts.
In chapter 3, we saw examples where a firm could increase its value by changing its risk. To use
derivatives to increase shareholder wealth, one has to know how they are priced as well as how they
can be used to transform a firms risk. A firm that takes a position in a mispriced derivative can lose
the value gain it expects from risk management even though it changes its risk as theory recommends.
Therefore, in this chapter we show how to price forward and futures contracts. In the four chapters
that follow we examine the uses of forward and futures contracts in risk management.
To price forward and futures contracts, we apply the fundamental method used to price
derivatives in general. This method is called pricing by arbitrage. Lets see how this method works
in principle for a derivative that is purchased now, has no cash flows until maturity, and makes a
payoff at maturity. For this derivative, the method of pricing by arbitrage requires us to find a
portfolio strategy that does not use the derivative, that has no cash flows until maturity, and has the
same payoff as the derivative. Since the portfolio strategy has exactly the same payoff as the
derivative, the current value of the derivative must be the same as the current value of the portfolio.
Otherwise, the portfolio strategy and the derivative yield the same payoffs for different prices. If the
same payoffs can be obtained for different prices, there is an arbitrage opportunity: one can
Chapter 5, page 2
simultaneously buy the payoff at the low price and sell it at the high price, making money for sure 
an unlikely and ephemeral event if traders actively seek out such opportunities and make them
disappear. Consequently, the value of the portfolio is the price of the derivative in the absence of
arbitrage opportunities.
In forward and futures markets, transaction costs are generally of little importance. We
therefore use the convenient simplifying assumption of perfect financial markets except at the end of
this chapter. Importantly for our analysis, this means that there are no transactions costs, no taxes,
no difference between borrowing and lending rates, and no restrictions on short sales. We start with
the simplest case: forward contracts on Tbills. In Section 5.2 we extend the analysis to forward
contracts on commodities, stocks, and currencies. With Section 5.3 we introduce futures contracts
and explain how and why they differ from forward contracts. We give a detailed example of how a
futures position evolves through time. In Section 5.4 we discuss how forward and futures prices
relate to each other and to future spot prices. Section 5.5 concludes.
Section 5.1. Pricing forward contracts on Tbills.
We introduced forward contracts in chapter 1 and have been using them ever since.
Remember that a forward contract is a purchase contract with delivery and payment taking place at
maturity of the contract, on terms agreed upon when the parties enter into the contract. We now want
to understand how the forward price is determined at the origination of a forward contract. For that
purpose, we study a forward contract on Tbills.
Lets consider a forward contract where the buyer agrees on March 1 to buy on June 1 Tbills
maturing on August 30 at the price of 97 cents per dollar of face value for a total face value of $1M.
Chapter 5, page 3
Money changes hands only at maturity of the contract. $0.97 is the forward price per dollar of face
value, i.e., the price agreed upon on March 1 for delivery on June 1 of bills that mature on August
30. In this case, the forward contract specifies:
1. The goods to be exchanged for cash: $1M of face value of Tbills maturing on August
30.
2. The date when the exchange takes place: June 1.
3. The price to be paid: $0.97 per dollar of face value.
Figure 5.1. shows a timeline of the various actions taken for a long position in the forward
contract, which is a position where you promise to buy the bills.
Section 5.1.A.Valuing a forward position at inception using the method of pricing by arbitrage.
Suppose we consider taking a long position in this contract in perfect capital markets. This
means that we promise to buy the bills at the forward price. It is common to call the investor with a
long position the long and the one with a short position the short. We would like to know whether
$0.97 is an advantageous forward price for us. The spot or cash market is the market where
transactions take place for delivery for the nearest possible settlement date. Tbills trades are settled
the next day, so that the spot market for Tbills involves next day delivery. Denote the spot price (also
called the cash market price) on June 1 of the Tbills delivered to the buyer on that day by P(June 1,
August 30) per dollar of face value. The payoff of the long position on June 1 will be (P(June 1,
August 30)  $0.97)*$1M. This is the payoff of receiving bills for $1M of face value, worth P(June
1, August 30)*1M, and paying a fixed amount for them, $0.97M. To know whether the forward price
is advantageous, we need to know the net present value of taking a long forward position. Since no
Chapter 5, page 4
money changes hands before maturity of the forward contract, the net present value of the position
is the present value of the payoff at maturity.
The problem with computing the present value of the payoff is that we do not know today
what the spot price of the delivered bills will be on June 1, since between now and then interest rates
will almost certainly change. One way that we can compute the present value of the payoff is to use
the capital asset pricing model. This approach requires us to compute the expected payoff, and then
discount it at the required discount rate implied by the beta of the payoff as discussed in chapter 2.
With this approach, different investors reach different conclusions if they have different expectations
about the payoff.
There is, however, a simpler way to compute the value of the forward position that does not
require us to know the statistical distribution of the payoff and that provides a unique price on which
all investors agree. This is because we can create a portfolio today without using the forward contract
that has the same payoff as the forward position. Because we can create such a portfolio, we can use
the method of pricing by arbitrage. A portfolio that has the same payoff as a financial instrument but
does not contain that financial instrument is called a replicating portfolio.
We now construct a replicating portfolio for the forward contract. The forward contract pays
(P(June 1, August 30)  $0.97)*$1M on June 1. We therefore have to construct a portfolio that pays
this amount at that date. We know from chapter 2 that the payoff of a portfolio is the sum of the
payoffs of the financial instruments included in the portfolio. Consequently, we can look at the
payoffs P(June 1, August 30)*1M and  $0.97m separately. We start with creating a portfolio that
pays $0.97M on June 1 since this is the easiest task and then create a portfolio that pays P(June 1,
August 30)*1m at the same date:
Chapter 5, page 5
1) Creating a portfolio that pays $0.97M on June 1. A negative payoff, like $0.97M,
means a cash outflow. Here, we have a cash outflow of a fixed amount on June 1. To create a
negative payoff at a future date, one borrows today and repays the principal and interest at maturity.
The negative payoff is then the amount one has to repay. With our assumptions of perfect financial
markets, we can borrow at the riskfree rate. To have to repay $0.97M, we borrow today the present
value of $0.97M, which is P(June 1)*$0.97M, where P(June 1) is the price of a Tbill on March 1 that
matures on June 1. A simple way to borrow is to sell Tbills short. Selling short a Tbill means
borrowing the Tbill and selling it. When the short sale is reversed, we buy the Tbill and deliver it
to the investor who lent us the Tbill initially. The gain from the short sale is the negative of the
change in the price of the Tbill. If the Tbill increases in value, we lose money with the short sale,
since we have to buy the Tbill back at a higher price than we sold it. Box 5.1. Repos and borrowing
using Treasury securities as collateral discusses the details of how short sales of Treasury securities
are usually implemented. Remember that we assume we can borrow at the riskfree rate because
financial markets are perfect. Let P(June 1) be $0.969388. We therefore receive today
0.969388*0.97*$1M, which is $0.940306M.
2) Creating a portfolio that pays P(June 1, August 30)*$1M on June 1. Tbills are
discount bonds, so that they have no cash flows until maturity. This means that a bill that matures on
August 30, worth P(August 30) today, is worth P(June 1, August 30) on June 1, and can be delivered
on the forward contract at that date. Lets assume that P(August 30) is equal to $0.95, so that we pay
$0.95*1M, or $0.95M to create the portfolio.
We have now completed the construction of our replicating portfolio. It has a long position
in Tbills that mature on August 30 which costs $0.95M and a debt with current value of
Chapter 5, page 6
$0.940306M, for a total value of $0.95M  $0.940306M or $0.009694M. Since Tbills that mature
on August 30 can be delivered on June 1 to fulfill the obligations of the forward contract, the
replicating portfolio is long the deliverable asset. Holding the portfolio until June 1, we then have
P(June 1, August 30)*1M  $0.97M, which is exactly the payoff of the long forward position.
We find that the replicating portfolio is worth $0.009694M. This means that a long forward
position has the same value. Yet, if we enter the forward contract, we pay nothing today. This creates
an arbitrage opportunity. Since we have two strategies that yield the same payoff but have different
costs, we would like to buy the payoff at a low price and sell it at a high price to make riskless profits.
Lets figure out how we can do this. In our example, the forward contract has value. We therefore
go long the contract. However, doing so involves taking a risk. We want to find a hedge that allows
us to eliminate this risk. Since the replicating portfolio has the same payoff as the forward contract,
it is a perfect hedging instrument. We want to sell that portfolio short, so that at maturity we owe the
payoff that we receive from the forward contract. To sell short a portfolio, we sell short the securities
that are long in the portfolio and buy the securities that are short in the portfolio. By taking a short
position in the replicating portfolio and a long position in the forward contract, we end up with
positions that cancel out at maturity so that we owe nothing then because going short the replicating
portfolio has the same payoff as going short the forward contract. Yet, today, we receive money for
going short the replicating portfolio and pay no money for going long the forward contract. We
therefore make money today without owing money in the future.
Lets make sure we understand exactly how the numbers work out if we go short the
replicating portfolio and long the forward contract to obtain a riskfree profit. Going short the
replicating portfolio involves a short sale of Tbills that mature on August 30 for $1M of face value
Chapter 5, page 7
and a riskfree investment that pays $0.97M on June 1. A short sale of Tbills maturing on August
30 for $1M face value means that we borrow $1M face value of these bills and sell them for $0.95M
today. When we reverse the short sale on June 1, we have to buy $1M face value of the Tbills for
P(June 1, August 30)*$1M and deliver the bills to our counterparty in the short sale. Therefore, the
short position in the Tbills requires us to pay P(June 1, August 30)*$1M on June 1. The investment
in the riskfree asset is worth $0.97M then by construction. Hence, this portfolio pays $0.97M 
P(June 1, August 30)*$1M on June 1, or using F as the forward price, F*$1M  P(June 1, August
30)*$1M, which is the payoff of a short forward position since with such a position we get F and
deliver the bills. The cash flow received on March 1 from establishing a short position in the
replicating portfolio is our riskfree profit:
Cash flow on March 1 from establishing a short position in the replicating portfolio
= [P(August 30)  P(June 1)F]*1M
= $0.95M  $0.969388*0.97*1M
= $0.95M  $0.940306M
= $0.009694M
Going short the replicating portfolio therefore replicates the payoff of a short forward position and
generates a positive cash flow on March 1. However, at maturity, the payoffs from the short position
in the replicating portfolio and the long position in the forward contract cancel out:
Payoff of short position in the replicating portfolio + Payoff of long forward position
Chapter 5, page 8
= [F  P(June 1, August 30)]*$1M + [P(June 1, August 30)  F]*$1M
= 0
This confirms that there is an arbitrage opportunity at the forward price of $0.97 since we make
money today and have to pay nothing at maturity. As long as the replicating portfolio has a value
different from zero, money can be made without risk. Infinite profits are for the taking if the forward
price and the Tbill prices do not change! If the forward contract is priced so that the replicating
portfolio has negative value, then we make money by buying that portfolio and taking a short forward
position! Table 5.1. shows that if the forward price is $0.99, we receive a positive cash flow today
of $9,694.12 without owing money later. The only case where we make no riskless profits is when
the replicating portfolio has zero value.
It follows from our analysis that the forward contract must have zero value at inception. If
a forward contract does not have zero value at inception, it means that one party to the contract
makes a gift to the other. For instance, if the contract has positive value for the long, it must have
negative value for the short, because the payoff of the short is the negative of the payoff of the long.
In real world markets, gifts get taken by traders who live for such opportunities and hence disappear
quickly. Consequently, the forward price must satisfy:
The replicating portfolio has zero value at inception of the contract
[P(August 30)  P(June 1)F]*$1M = 0
Solving this equation for F gives the following result:
Chapter 5, page 9
F =
P(August 30)
P(June 1)
With the numbers of our example, this means that:
[$0.95  $0.969388*F]*$1M = 0
Solving this equation for the unknown F, we get F = $0.98. With this forward price, the replicating
portfolio for the long position has no value and there is no arbitrage opportunity.
The condition that the forward price must be such that the replicating portfolio for the
forward contract has zero value has an important economic interpretation. With the forward contract,
we pay a price known today, F, for the bills at maturity of the contract. Suppose that the forward
contract does not exist and we want to pay a known price on June 1 for $1M face value of bills
maturing on August 30. The way to do that is to buy the bills maturing on August 30 today and
finance the purchase. We pay P(August 30)*$1M for the bills. If we finance them, at maturity we
have to repay Exp[r*0.25]*P(August 30)*$1M, where r is the continuously compounded annual rate
of interest on a bill that matures on June 1. By the definition of Tbills, the price of a Tbill that
matures on June 1 is P(June 1) = Exp[r*0.25]. Consequently, the cost to us of buying the bills
maturing on August 30 on credit is that we have to pay P(August 30)*$1M/P(June 1) on June 1 when
we repay the loan, which is equal to the price we would pay using the forward contract with the price
obtained with our formula. This is not surprising since the two ways of buying the bills and paying
for them on June 1 should have the same price. Viewed this way, the replicating portfolio can be
Chapter 5, page 10
F =
P(t + j)
P(t + i)
thought of as a portfolio where we buy the bills and finance them with a loan. On June 1, the cost of
owning the bills with this strategy is that we have to pay an amount equal to the initial cost of the bills
plus the financing costs. This amount has to be the forward price to avoid arbitrage opportunities.
Section 5.1.B. A general pricing formula.
Using our notation, we have shown that the forward price and the Tbill prices must be such
that P(August 30)*1M  P(June 1)F*1M = 0, which implies that F = P(August 30)/P(June 1). Our
analysis holds equally well if the forward contract has a different maturity or requires delivery of a
bill with a different maturity. Consequently, we have a general formula for the pricing of forward
contracts on Tbills:
Formula for the pricing of forward contracts on Tbills
The forward price per dollar of face value, F, of a contract entered into at t for delivery of bills at t+i
that mature at t+j must be such that the replicating portfolio for a forward position has no value at
inception:
Price at time t of deliverable Tbill with maturity at time t+j  Present value of forward price to be
paid at time t+i = 0
P(t+j)  P(t+i)F = 0 (5.1.)
Dividing the formula by P(t+i) shows that:
(5.2.)
In our above discussion, P(t+j) = P(August 30) = 0.95 and P(t+i) = P(June 1) = 0.969388, so that F
Chapter 5, page 11
= 0.98.
Section 5.1.C. Pricing the contract after inception
Consider now the following situation. Suppose we entered a short forward position in the
contract discussed in section 5.1.A. with a forward price satisfying equation (5.2.) of $0.98, so that
we committed to sell $1M face value of 90day Tbills in 90 days for $0.98 per dollar of face value.
Time has now elapsed, so that we are on April 15. Lets figure out the value of the position.
We showed that there is a replicating portfolio that has the same payoff as a short forward
position. This replicating portfolio has an investment in Tbills maturing on June 1 that pays $0.98M
then and a short position in Tbills that mature on August 30. This portfolio has zero value at
origination of the contract, but on April 15 its value may have increased or decreased. To price the
forward position, we therefore have to price the portfolio on April 15 to get the value of a portfolio
on that date that has the same payoff as the short forward position. Hence, the value of the short
forward position is given by:
Value of replicating portfolio for short forward position on April 15
= [P(April 15, June 1)F  P(April 15, August 30)]*$1M
= [P(April 15, June 1)*0.98  P(April 15, August 30)]*$1M
This portfolio replicates the payoff of the short forward position since on June 1, it is worth $0.98M 
P(June 1, August 30)*$1M. Lets check how this works with an example. Suppose that P(April 15,
June 1) = $0.965 and P(April 15, August 30) = $0.93605. In this case, we have that:
Chapter 5, page 12
Value of replicating portfolio for short forward position on June 15
= [P(June 15, June 1)F  P(June 15, August 30)]*1M
= 0.965*$0.98M  $0.93605M
= $0.00965M
It follows from this that the short forward position has gained in value from March 1 to June 15.
We can think of valuing the short forward position on April 15 in a different way. Suppose
that we want to find out how much we would receive or pay to get out of the short forward position.
The way to get out of a forward position is to enter a new forward position of opposite sign: the
short enters a long forward position for the same date and with the same bills to be delivered. A
contract originated on April 15 for delivery on June 1 of Tbills maturing on August 30 would have
to be priced using our formula. Our formula yields a price of $0.97. This price would have created
arbitrage opportunities on March 1, but since interest rates have changed, it is a price that creates no
arbitrage opportunities on April 15. We could therefore cancel our position on April 15 by taking a
long forward position to buy on June 1 Tbills maturing on August 30 for $0.97 per dollar of face
value. On June 1, we would receive $0.98M and pay $0.97M, using the bills received for delivery on
the short contract. Consequently, we would make a net gain of $0.01M irrespective of interest rates
on that date. Since we would receive $0.01M on June 1 if we cancel our position by entering an
offsetting contract, it must be that the value of the position on April 15 is the present value of
$0.01M. This means that the value of the position per dollar of face value on April 15 is the present
value of the difference between the price at inception (the amount you receive by delivering on your
long position entered on March 1) and the new forward price (the amount you pay by delivering on
Chapter 5, page 13
your short position entered on April 15), where the discounting takes place from the maturity date
of the contract to April 15. This value is $0.00965. Not surprisingly, this is exactly the value of the
replicating portfolio per dollar of face value.
Our analysis therefore shows that:
Formula for the value of a forward position
The value at date t+, of a forward position per dollar of face value maturing at date t+i (t+i > t+,)
requiring delivery of a bill maturing at date t+j is the value of the replicating portfolio at t+,:
P(t+,,t+i)F  P(t+,,t+j) where j > i (5.3.)
The value of a short position per dollar of face value is minus one times the value of the replicating
portfolio at that date:
P(t+,,t+j)  P(t+,,t+i)F (5.4.)
Section 5.2. Generalizing our results.
In the previous section, we learned how to price a forward contract on a Tbill. The key to
our approach was our ability to construct a replicating portfolio. We were then able to use the
method of pricing by arbitrage which states that the value of the forward position must be equal to
the value of the replicating portfolio. The replicating portfolio consists of a long position in the
deliverable asset financed by borrowing.
Consider now a forward contract that matures June 1 on a stock that pays no dividends. Let
S(June 1) be price of the deliverable asset on the cash market on June 1, the stock price at maturity
of the contract, and F be the forward price per share. The payoff of a long forward position is S(June
1)  F. We already know that we replicate F by borrowing the present value of F so that we have to
Chapter 5, page 14
repay F at date June 1. We have to figure out how to create a portfolio today that pays S(June 1) at
maturity. Because the stock pays no dividends, the current value of the stock to be delivered at
maturity of the forward contract is the stock price today. By buying the stock on March 1 and holding
it until June 1, we own the deliverable asset on June 1. Consequently, our replicating portfolio works
as follows: buy one unit of the stock today and sell short Tbills maturing on June 1 for proceeds
equal to the present value of the forward price. With this portfolio, we spend S(March 1) to purchase
the stock and sell short Tbills for face value equal to F. On June 1, we have to pay F to settle the
shortsale. After doing so, we own the stock. If we had used a forward contract instead, we would
have paid F on June 1 as well. The forward price must be such that the replicating portfolio has zero
value, therefore S(March 1)  P(June 1)F must be equal to zero. Solving for the forward price, we
have that F is equal to A(March 1)/P(June 1). If the forward price differs from the value given by our
formula, there exists an arbitrage opportunity.
We can now price a forward contract on a stock. However, we can do much more. In all cases
considered, we had a situation where the current value of the asset delivered at maturity of the
contract is the current spot price of the asset. As long as the deliverable assets current value is its
spot price, we can find the forward price by constructing a replicating portfolio long the deliverable
asset today financed by borrowing the present value of the forward price. We can therefore get a
general formula for the forward price F for a contract where S(t) is the current price of the asset
delivered at maturity of the contract at t+i:
General formula for the forward price F on an asset with current price S(t) and no payouts
before maturity of the contract at t+i
The replicating portfolio for the contract must have zero value, which implies that:
Chapter 5, page 15
F =
S(t)
P(t + i)
F =
S(t)  P(t + D(t +
P(t +i)
h h
h
h=N
) )
=
1
S(t)  P(t+i)F = 0 (5.5.)
Solving this expression for F yields:
(5.6.)
The assumption of no cash flows for the deliverable asset before maturity of the contract is extremely
important here. Lets find out what happens when this assumption does not hold. Suppose we
construct a replicating portfolio for a forward contract on a stock that matures on June 1 and the
stock pays a dividend D on April 15. For simplicity we assume that the dividend is already known.
In this case, the forward contract requires delivery of the stock exdividend, but the current price of
the stock includes the right to the dividend payment. The stock today is not the deliverable asset. The
deliverable asset is the stock without the dividend to be paid before maturity of the contract.
Consequently, the cost today of buying the replicating portfolio that pays S(June 1) on June 1 is no
longer S(March 1), but instead is S(March 1) minus the present value of the dividend, S(March 1) 
P(April 15)D. The portfolio to replicate a payoff of F on June 1 is the same as before. We can
generalize this to the case of multiple payouts and arbitrary dates:
Forward price for a contract on an asset with multiple payouts before maturity
The forward price F at t for delivery at date t+i of an asset with price S(t) at time t that has N
intermediate payouts of D(t+)
h
), h = 1,...,N, is given by:
(5.7.)
Chapter 5, page 16
F =
100  0.98*2  0.96*2  0.93*2  0.90*2
0.90
= 102 73 .
Lets look at an example. Consider a forward contract entered into at date t with delivery in
one year of a share of common stock that pays dividends quarterly. The current price of the stock is
$100. The dividends are each $2 and paid at the end of each quarterly period starting now. The
discount bond prices are $0.98 for the zerocoupon bond maturing in three months, $0.96 for the
bond maturing in six months, $0.93 for the bond maturing in nine months, and $0.90 for the bond
maturing in one year. Consequently, we have S(t) = 100, P(t+i) = P(t+1) = 0.90, P(t+0.75) = 0.93,
P(t+0.5) = 0.96, P(t+0.25) = 0.98, and D(t+1) = D(t+0.75) = D(t+0.5) = D(t+0.25) = 2. Using the
formula, we have:
If we had ignored the dividends, we would have obtained a forward price of $111.11. The forward
price is much higher when dividends are ignored because they reduce the cost of the replicating
portfolio  they are like a rebate on buying the replicating portfolio.
The analysis in this section extends naturally to a forward contract on a portfolio. The
deliverable asset could be a portfolio containing investments in different stocks in specified quantities.
For instance, these quantities could be those that correspond to a stock index like the S&P 500. In
this case, we would have a forward contract on the S&P 500. The S&P 500 index is equivalent to
the value of a portfolio invested in 500 stocks where the investment weight of each stock is its market
value divided by the market value of all the stocks in the index. One can therefore construct a
portfolio of stocks whose return exactly tracks the S&P 500.
1
A technical issue should be mentioned here. Not all countries have Tbills, but in many
countries there is the equivalent of Tbills, namely a default free asset that pays one unit of local
currency at maturity. Whenever we talk about a Tbill for a foreign country, we therefore mean an
instrument that is equivalent to a U.S. Tbill.
Chapter 5, page 17
Section 5.2.A. Foreign currency forward contracts.
Consider a forward contract where you promise to purchase SFR100,000 on June 1 at price
F per unit of foreign currency agreed upon on March 1. The price of the deliverable for spot delivery,
the Swiss Franc, is S(June 1) at maturity of the contract. The payoff of the contract at maturity is
100,000S(June 1)  F. We already know that we can replicate F by borrowing the present value of
F. Lets now replicate 100,000S(June 1). You can purchase today an amount of SFRs such that on
June 1 you have SFR100,000 by buying SFR Tbills for a face value of SFR100,000 maturing on June
1.
1
The cost of buying the SFR Tbills in dollars is the cost of SFR Tbills maturing on June 1 per
SFR face value, P
SFR
(June 1), multiplied by the exchange rate today, S(March 1), times 100,000,
which is 100,000S(March 1)P
SFR
(June 1). The present value of the forward price times 100,000,
100,000P(June 1)F, must be equal to 100,000P
SFR
(June 1)S(March 1) to insure that the replicating
portfolio has no value. Consequently, the forward price F is S(March 1)P
SFR
(June 1)/P(June 1).
Generalizing the formula for the forward price to a contract entered into a t and maturing at
t+i, we obtain the following result:
Pricing formula for a foreign exchange forward contract
Let S(t) be the current spot price of the foreign currency and P
FX
(t+i) the price of a foreign currency
Tbill with one unit of foreign currency face value maturing at date t+i. A forward contract on the
foreign currency maturing at date t+i originated at date t must have a forward price F per unit of
foreign currency such that the replicating portfolio has zero value at origination:
Chapter 5, page 18
F =
S(t)P (t i)
P(t i)
FX
+
+
S(t)P
FX
(t+i)  P(t+i)F = 0 (5.8.)
This formula implies that the forward price must be:
(5.9.)
Lets consider an example of a contract entered into at t that matures one year later. Suppose the SFR
is worth 70 cents, P
FX
(t+1) = SFR0.99005, P(t+1) = $0.951229. Using our formula, we have that F
= $0.7*0.99005/0.951229 = $0.72857. In this case, the forward price of the SFR is more expensive
than its current spot price. For foreign currencies, the current spot price is the spot exchange rate
while the forward price is called the forward exchange rate. If the forward exchange rate is above the
spot exchange rate, the currency has a forward premium. The forward exchange rate pricing formula
is often expressed using interest rates. Box 5.2. Interest rate parity shows that the interest rate
formulation can be used profitably to understand how interest rates across countries are related.
Section 5.2.B. Commodity forward contracts.
Lets conclude this section by considering a forward contract on a commodity, say gold.
Suppose that on March 1 you know that you will want 1,000 ounces of gold on June 1. You can buy
the gold forward or you can buy it today and finance the purchase until June 1. There is a difference
between holding the gold now versus holding the forward contract: holding gold has a convenience
yield. The convenience yield is the benefit one derives from holding the commodity physically. In the
case of gold, the benefit from having the commodity is that one could melt it to create a gold chain
that one can wear. Hence, if the cash buyer has no use for gold, he could lend it and whoever borrows
Chapter 5, page 19
F =
exp(c *i)S(t)
P(t + i)
it would pay the convenience yield to the lender. The rate at which the payment is determined is called
the gold lease rate. This means that the cost of financing the gold position is not the Tbill yield until
maturity of the forward contract, but the Tbill yield minus the convenience yield. As before, lets
denote the cash market or spot price of the deliverable on March 1 by S(March 1). In this case,
S(March 1) is the gold price on March 1. Further, lets assume that the convenience yield accrues
continuously at a rate of c% p.a. To create a replicating portfolio for a long position in the forward
contract, one has to hold exp(0.25c) units of gold and sell short Tbills of face value F. To create
a replicating portfolio for a short position in the forward contract, one has to sell the commodity
short, which involves compensating the counterparty for the loss of the convenience yield. To sell
gold short, one therefore has to pay the lease rate. Though the lease rate for gold is relatively
constant, the convenience yield of other commodities can vary dramatically as holders may gain a
large benefit from holding the commodity  chainsaws are very valuable the day following a hurricane,
a benefit that is not shared by chainsaws bought forward with delivery a month after the hurricane.
This approach gives us a formula for the forward price for a commodity:
Forward price formula on a commodity with a convenience yield
The forward price at date t, F, for delivery of one unit of a commodity at date t+i that has a price
today of S(t) and has a convenience yield of c% per unit of time is priced so that the replicating
portfolio has zero value:
exp(c*i)S(t)  P(t+i)F = 0 (5.10.)
Consequently, the forward price must satisfy:
(5.11.)
Chapter 5, page 20
Lets look at an example of a contract entered into at t that matures 90 days later. Suppose that the
price of gold today is $40 an ounce, the convenience yield is 2% p.a. continuously compounded, and
the price for a 90day discount bond is $0.98 per dollar of face value. We have S(t) = $40, c = 0.02,
i = 0.25, and P(t+i) = $0.98. Consequently:
F = S(t)exp(c*i)/P(t+i) = $40exp(0.02*0.25)/0.98 = $40.6128
Without the convenience yield, the replicating portfolio would have been more expensive and as a
result the forward price would have been higher. The forward price without the convenience yield
is $40.8163.
Often, it is costly to store the deliverable commodity. For instance, replicating a forward
contract on heating oil requires storing the oil. Storage costs are like a negative convenience yield:
they make the forward contract more advantageous because buying forward saves storage costs.
Whereas the convenience yield lowers the forward price relative to the spot price, the storage costs
increase the forward price relative to the spot price. To see this, lets look at the case where the
storage costs occur at a continuous rate of v% per year and the contract matures in 90 days. We can
think of storage costs as a fraction of the holdings of oil that we have to sell to pay for storage or we
can think of oil evaporating because it is stored. To create a replicating portfolio for the long position
in heating oil, we have to buy more oil than we need at maturity for delivery because we will lose
some in the form of storage costs. Hence, to have one unit of oil at maturity, we need to buy
exp[0.25v] units of oil now. If oil has both storage costs and a convenience yield, we require
exp[0.25(vc)] units of oil now. To get a general formula for the pricing of forward contracts, we also
2
Note that this general formula can be extended to allow time variation in r, v, c, and d.
Further, discrete payouts or storage costs can be accommodated in equation (5.13.) by
discounting these costs on the lefthand side using the appropriate discount rate. Viewed this way,
the current value of the good delivered at date t+i is its current price plus the present value of
storage costs minus the present value of holding the good (payouts and convenience yield).
3
The current usage among economists is to use backwardation to designate the excess of
the expected spot price over the forward. While everyone can agree whether or not a forward
price exhibits backwardation in the sense of Keynes, people can disagree as to whether a forward
Chapter 5, page 21
want to allow for cash payouts at a rate d. In this case, we need exp[0.25(vcd)] units of the
underlying in the replicating portfolio. For a contract entered into at t and maturing at t+i, this
reasoning leads to the following formula for the forward price:
General formula for the forward price
A forward contract for delivery of a good at date t+i with price S(t+i) at that date available today for
price S(t), with continuously computed payout rate of d% per year, convenience yield of c%, and
storage costs of v% must have a forward price F such that the replicating portfolio has zero value
2
:
exp[(vcd)i]S(t)  P(t+i)F = 0 (5.12.)
If the continuouslycompounded yield on the Tbill maturing at date t+i is r% p.a., the forward price
then satisfies:
exp[(r+vcd)*i]*S(t) = F (5.13.)
Lets look at an example. Consider a commodity that costs $50. Suppose that the interest rate is 10%,
storage costs take place at the rate of 6%, and there is a convenience yield of 4%. The forward
contract is for 90 days. Using our formula, we have that exp[(0.10 + 0.06  0.04)*90/360]*$50 =
$51.5227. This means that the forward price exceeds the spot price of the commodity. Keynes, in his
work on forward pricing, defined the price for future delivery to be in contango when it exceeds the
spot price and in backwardation otherwise.
3
price exceeds the expected spot price.
Chapter 5, page 22
Assuming that r, v, c, and d do not depend on S(t), equation (5.13.) shows that the forward
price has the following properties :
(1) The forward price increases with the current price of the good to be delivered at maturity
of the contract. This results from the fact that the replicating portfolio of the long forward position
is long in that good.
(2) The forward price increases with the interest rate. In the replicating portfolio, one sells
Tbills short for a face amount F. As the interest rate increases, the shortsale proceeds fall which
increases the value of the portfolio. Hence, to keep the value of the portfolio at zero, one has to
increase short sales.
(3) An increase in storage costs increases the forward price. This is because one has to buy
more of the good to have one unit at maturity. As storage costs increase, it becomes more
advantageous to buy forward for a given forward price, and the forward price has to increase to
compensate for this.
(4) An increase in the convenience yield and the payout rate decrease the forward price. The
convenience yield and the payout rate provide an added benefit to holding the good as opposed to
buying it forward, thereby making the forward less attractive and requiring a fall in the forward price.
Figure 5.2. shows the difference between the forward price and the spot price as maturity
changes and as (vcd) changes. In this figure, the forward price can be greater or smaller than the
spot price. If (r + v  c  d) is positive, the forward price exceeds the spot price. The sum (r + v  c 
d) is generally called the cost of carry, in that it is the cost (in this case expressed as a continuously
compounded rate) of financing a position in the underlying good until maturity of the contract. For
Chapter 5, page 23
gold, c is small (lease rates are typically of the order of 2%) and v is trivial. For oil, c can be
extremely large relatively to v. Hence, typically the present value of the forward price of gold exceeds
the spot price, while the present value of the forward price for oil is lower than the spot price.
It is important to note that the arbitrage approach cannot always be used to price forward
contracts. In particular, it may not be possible to establish a short position. If selling short the
commodity is not possible, then the forward price can be lower than the formula given above. This
is because the only way to take advantage of a forward price that is too low relative to the one
predicted by the formula without taking risk is to buy forward and sell the commodity short to hedge
the forward position. However, if it is difficult to sell short, this means that one has to make an
extremely large payment to the counterparty in the short sale. Consequently, use of the commodity
is extremely valuable and the convenience yield is very high. This means that there is a convenience
yield for which the formula holds. A bigger difficulty is that for perishable commodities the replicating
portfolio approach becomes meaningless because holding the portfolio becomes more expensive than
the spot price of the commodity. Think of replicating a long position in a oneyear forward contract
on roses! In this case, the forward contract has to be priced using a model that specifies the risk
premium that investors require to take a long position in the forward contract (e.g., the CAPM) rather
than the arbitrage approach.
Section 5.3. Futures contracts.
Lets consider more carefully the situation of a firm that has a long forward position to buy
Euros. Suppose that the contract matures in one year. The forward position makes money if the Euro
at the end of the year exceeds the forward price, provided that the forward seller honors the terms
Chapter 5, page 24
of the contract at maturity. If the forward seller cannot deliver at maturity because of a lack of
financial resources or other reasons, the forward contract is useless and the gain the firm expected
to make does not materialize. The risk that the counterparty in a derivatives contract fails to honor
the contract completely is called counterparty risk. It means that there is a risk of default and, when
the firm enters the contract, it has to take that risk into account. If the risk of default is too large, the
forward contract is useless or worse. Note that if the firm makes losses on the contract, the seller
makes a profit by delivering the Euros and therefore will do so. Hence, for the buyer, default risk
means that the distribution of the gain from the forward contract changes so that losses become more
likely. To adjust for the impact of default risk, the buyer wants a lower forward price.
The problem with default risk for the buyer in our example is that it requires careful
examination of the forward sellers business. This increases the costs of forward contracting. One
way to eliminate this difficulty is for the forward buyer to enter a contract only if the counterparty
has a high debt rating indicating a low probability of default. Another way to avoid this problem is
to require the seller to post a bond that guarantees performance on the contract. This can work as
follows. When entering the contract, the seller sets aside an amount of money with a third party,
possibly in the form of securities, that he forfeits if he does not deliver on the forward contract. If the
value of the assets deposited as collateral is large enough, default becomes unlikely. The difficulty is
that such an arrangement has to be negotiated and the party who holds the collateral has to be
designated and compensated. Further, if the losses that can occur are large over the life of the
contract, then the collateral will have to be quite large as well. We also saw in chapter 3 that firms
often hedge to avoid situations where they might lack funds to invest and face difficulties in raising
funds in the capital markets. Forcing a firm to post a large amount of collateral is therefore likely to
Chapter 5, page 25
prevent it from hedging since it would force the firm to set aside either funds that have a high
opportunity cost or funds that it does not have. Requiring the posting of a large amount of collateral
makes it less likely that firms and individuals will want to enter the contract.
Rather than posting a collateral that covers possible losses for the whole life of the contract,
it seems more efficient to require a smaller collateral that covers potential losses over a small period
of time, but then to transfer the gains and losses as they accrue. In this case, whenever the collateral
becomes insufficient to cover potential losses over a small period of time, it is replenished and if the
counterparty fails to do so, the contract is closed. Since gains and losses are transferred as they
accrue, the contract can be closed without creating a loss for one of the parties to the contract. With
such a way of dealing with default risk, the seller receives his gains as they accrue and if he starts to
make losses, he pays them as they accrue. This arrangement can be renewed every period, so that
over every period the forward seller has no incentive to default because his posted collateral is
sufficient to cover the potential losses during the period. If the forward seller is concerned about
default of the forward buyer, the same arrangement can be made by the buyer.
Section 5.3.A. How futures contracts differ from forward contracts.
The best way to view futures contracts is to think of them as forward contracts with added
features designed to make counterparty risk economically trivial. Futures contracts are contracts for
deferred delivery like forward contracts, but they have four important features that forward contracts
do not have. First and most importantly, gains and losses are paid by the parties every day as they
accrue. This procedure, called marking the contract to market, is equivalent to closing the contract
at the end of each day, settling gains and losses, and opening a new contract at a price such that the
Chapter 5, page 26
new contract has no value. Second, collateral is posted to ensure performance on the contract. Third,
futures contracts are standardized contracts that trade on organized exchanges. Fourth, the
counterparty in a long (short) futures contract position is not the short (long) but rather an institution
set up by the exchange called the clearinghouse that has enough capital to make default extremely
unlikely. We discuss the significance of these features of futures contract in the remainder of this
section.
To open a futures contract in the U.S., we have to open a commodity trading account with
a futures commission merchant regulated by the Commodity Futures Trading Commission and deposit
enough money in it to cover the required initial collateral, called the contracts initial margin. The
initial margin is set by the broker, but has to satisfy an exchange minimum. Like forward contracts,
futures contracts have no value when entered into. Since the long does not make a payment to the
short when he opens a futures contract, the futures contract would have negative value for the short
at origination if it had positive value for the long. In this case, therefore, the short would not enter
the contract. The same reasoning explains why the contract cannot have positive value for the short
at origination. The long makes a gain if the price increases after opening the contract and the short
loses. If we make a loss on a day, our account is debited by the loss. The amount that our account
changes in value on a given day is called that days settlement variation. After having paid or
received the days settlement variation, our futures position has no value since gains and losses are
paid up. After opening the futures position, the balance in our account has to exceed the
maintenance margin before the start of trading each day. The maintenance margin is lower than the
initial margin. Following losses, we receive a margin call if the account balance falls below the
maintenance margin. In this case, we have to replenish the account to bring its balance to the initial
Chapter 5, page 27
margin. If we make gains, we can withdraw the amount by which the margin account exceeds the
initial margin.
Forward contracts are generally traded over the counter. Therefore, any contract that two
traders can agree on can be made. No exchange rules have to be satisfied. For instance, foreign
currency forward contracts are traded on a worldwide market of traders linked to each other through
phones and screens. The traders handle default risk by having position limits for the institutions they
deal with. They do not trade at all with institutions that have poor credit ratings. If they are willing
to trade, they are willing to trade contracts of any maturity if the price is right. In contrast, futures
contracts are traded on futures markets that have welldefined rules. The trading takes place in a
designated location and available contracts have standardized maturities and sizes. Because the
contracts are traded daily, a futures position can always be closed immediately. To do that, all we
have to do is enter the opposite futures position to cancel out the initial position. If we close the
contract this way in the middle of the day, we are still responsible for the change in the value of the
contract from the beginning of the trading day to the middle of the trading day.
With forward contracts the counterparty is always another institution or individual.
Consequently, when A and B enter in a forward contract where A promises to buy SFRs from B, A
is the counterparty to B. In contrast, if A enters a long futures position in SFR futures contract and
B takes the offsetting short position, A is not the counterparty to B. This is because, immediately
after A and B have agreed to the futures trade, the clearing house steps in. The clearinghouse will
take a short position with A so that it will be responsible for selling the SFR to A and it will take a
long position with B so that it will be responsible for buying the SFR from B. The clearinghouse
therefore has no net futures position  it has offsetting long and short positions. However, the long
Chapter 5, page 28
and the short in a futures contract pay or receive payments from the exchanges clearinghouse. This
means that if one takes a position in a futures contract, the only default risk one has to worry about
is the default risk of the clearinghouse. Margins corresponding to a brokers net positions (the
position left after the short positions are offset against the long positions to the extent possible) are
deposited with the clearinghouse. Further, clearinghouses are wellcapitalized by their members and
their resources are wellknown. Consequently, default risk in futures contracts is almost nil, at least
for wellknown exchanges. Clearinghouses in the U.S. have been able to withstand successfully
dramatic shocks to the financial system. For instance, more than two billion dollars changed hands
in the clearinghouse of the Chicago Mercantile Exchange during the night following the crash of
October 19, 1987. Yet, the futures markets were able to open the next morning because all payments
to the clearinghouse had been made. The fact that the final payments were made on Tuesday morning
with a few minutes to spare and that the CEO of a major bank had to be woken up in the middle of
the night to get a transfer done shows that the markets came close to not opening on that day,
however.
To understand the importance of the clearinghouse, lets look at an example. Nick Leeson of
Barings Securities was an apparently very successful futures and options trader for his firm since he
arrived in Singapore in the spring of 1992. However, by the beginning of 1995, he had accumulated
extremely large positions that were designed to make a profit as long as the Nikkei index stayed
relatively stable in the 19,00021,000 range. Things started poorly for Leeson from the start of 1995,
but on January 17 they got much worse as an earthquake devastated the industrial heartland of Japan
around Kobe. On the day of the quake, the Nikkei was at 19,350. Two weeks later it was at 17,785.
Leesons positions had large losses. To recover, he pursued a strategy of taking a large long position
Chapter 5, page 29
in the Nikkei futures contract traded in Singapore. It is not clear why he did so. He may have believed
that the Nikkei had fallen too much so that it would rebound, or worse, that he himself could push
the Nikkei up through his purchases. In the span of four weeks, his position had reached 55,399
contracts. As these contracts made losses, margin calls were made and Barings had to come up with
additional money. By Friday, February 25, Barings had losses of 384 million pounds on these
contracts. These losses exceeded the capital of the Barings Group, the parent company. Barings was
effectively bankrupt and unable to meet margin calls. For each long position of Leeson, there was an
offsetting short position held by somebody else. Had Leesons contracts been forward contracts
without collateral, the forward sellers would have lost the gains they expected to make from the fall
in the Nikkei index since Barings, being bankrupt, could not honor the contracts. However, the
contracts were futures contracts, so that between the short and long positions, there was the
clearinghouse of the Singapore futures exchange. No short lost money. The clearinghouse made
losses instead.
Section 5.3.B. A brief history of financial futures.
Futures markets exist in many different countries and have quite a long history. For a long
time, these markets traded mostly futures contracts on commodities. In the early 1970s, exchange
rates became more volatile and many investors wanted to take positions to exploit this volatility. The
interbank market did not welcome individuals who wanted to speculate on currencies. With the
support of Milton Friedman, an economist at the University of Chicago, the Chicago Mercantile
Exchange started trading foreign currency futures contracts. These contracts were followed by
contracts on Tbills, Tbonds, and Tnotes. Whereas traditional futures contracts required physical
4
Let a, b, and c be three stock prices. A geometric average of these prices is (a*b*c)
1/3
.
Chapter 5, page 30
delivery if held to maturity, the exchanges innovated by having contracts with cash delivery. In the
beginning of the 1980s the Kansas City Board of Trade started the trading of a futures contract on
a stock index. Since indices are copyrighted, trading a futures contract on an index requires approval
of the holder of the copyright. The Kansas City Board of Trade was able to enter an agreement with
Value Line to use their index. The Value Line index is a geometric average of stock prices, so that
it does not correspond directly to a basket of stocks.
4
There is no way to deliver the Value Line
Index. Consequently, a futures contract on the Value Line Index must be settled in cash.
Subsequently, the Chicago Mercantile Exchange started trading a contract on the S&P 500 index. As
explained earlier, the performance of the S&P 500 can be exactly replicated by holding a portfolio
that has the same composition as the index. Nevertheless, the exchange chose delivery in cash since
such a delivery simplifies the procedure considerably. Since then, many more financial futures
contracts have started trading all over the world.
The experience with stock index futures shows that our arbitrage approach is far from
academic. Many financial firms opened arbitrage departments whose role was to exploit discrepancies
between the S&P 500 futures price and the cash market price. These departments would take
advantage of automated trading mechanisms whereby they could sell or buy a large portfolio whose
return carefully tracked the return of the S&P 500 with one computer instruction. For a number of
years, these arbitrage transactions were profitable for the firms with the lowest transaction costs that
quickly managed to take advantage of discrepancies. In a paper evaluating the profitability of
arbitrage strategies during the 1980s on a futures contract on an index similar to the Dow Jones
index, Chung (1991) found that only firms that had low transaction costs and traded within a few
Chapter 5, page 31
minutes from observing the discrepancy could make money. Whereas in the late 1980s index arbitrage
was often blamed for creating artificial volatility in stock prices, there is little discussion about stock
index arbitrage in the 1990s. Arbitrage opportunities seem much less frequent than they were in the
1980s.
Section 5.3.C. Cash versus physical delivery.
Typically, participants in futures markets do not take delivery. They generally close out their
position before maturity. The ability to close a position before maturity is especially valuable for the
contracts that do not have cash delivery  otherwise, the long in the pork bellies contract would have
to cope with a truck of pork bellies. Even though participants typically do not take delivery, contracts
where delivery of physicals takes place at maturity  i.e., pork bellies for the pork bellies contract or
Tbonds for the Tbond contract  have some additional risks compared to the contracts with cash
delivery. Consider a futures contract on a specific variety of grain. A speculator could be tempted,
if she had sufficient resources, to buy this variety of grain both on the futures market and on the cash
market. At maturity, she might then be in a position where the sellers on the futures market have to
buy grain from her to deliver on the futures market. This would be an enviable position to be in, since
she could ask a high price for the grain. Such a strategy is called a corner. If delivery were to take
place in cash for that variety of grain, the futures sellers would not need to have grain on hand at
maturity. They would just have to write a check for the change in the futures price over the last day
of the contract.
In our example, a corner is more likely to be successful if the variety of grain is defined so
narrowly that its supply is quite small. As the supply of the deliverable commodity increases, a corner
Chapter 5, page 32
requires too much capital to be implemented. If a variety of grain has a small supply, the solution is
to allow the short to deliver other varieties that are close substitutes, possibly with a price adjustment.
This way, the deliverable supply is extended and the risk of a corner becomes smaller.
Financial futures contracts that require physical delivery generally allow the short to choose
among various possible deliverable instruments with price adjustments. Obviously, there is no risk
that a long could effect a corner on the Euro. However, for Tbonds and Tnotes, there would be
such a risk if only one issue was deliverable. Box 5.3. The cheapest to deliver bond and the case
of Fenwick Capital Management shows how this issue is handled for the Tbonds and Tnotes
contracts and provides an example of a successful corner in the Tnote futures contract.
Section 5.3.D. Futures positions in practice: The case of the SFR futures contract.
To understand better the workings of futures contracts, lets look at a specific case where you
take a long position in a SFR futures contract on March 1, 1999, and hold this position during the
month of March. Exhibit 5.1. shows the futures prices for currencies on March 1, 1999, in the Wall
Street Journal. On that day, we must establish an account with a certified broker if we do not have
one already. When the position is opened, the broker determines the initial margin that we must
deposit and the maintenance margin. The initial and maintenance margins cannot be less than those
set by the exchange, but they can be more. Whenever we make a loss, it is withdrawn from our
account. The change in price that determines whether we made a loss or a gain over a particular day
is determined by the change in the settlement price. The settlement price is fixed by the exchange
based on prices at the end of the trading day. An increase in the settlement price means that we gain
with a long position. This gain is then put in the margin account. A decrease in the settlement price
Chapter 5, page 33
means that we committed to buy SFRs at a higher price than the one we could commit now, so we
made a loss.
On March 1, 1999, the settlement price on the June contract is $0.6908. The contract is for
SFR125,000. This means that the value of SFR125,000 using the futures price of the June contract
on March 1 is $86,350. Many futures price contracts have price limits. In the case of the SFR
contract, the limit is effectively a change of $0.04 from a reference price determined during the first
fifteen minutes of trading. If the limit is hit, trading stops for five minutes. After the five minutes, the
limit is expanded and trading resumes as long as the new limit is not hit immediately. There is some
debate as to the exact role of price limits. Some argue that they make it possible for providers of
liquidity to come to the markets and smooth price fluctuations; others argue that they are another tool
the exchange uses to limit default risk. Figure 5.3. shows how the June 1999 SFR futures contract
price evolves during the month of March 1999. The contract price at the end of the month is lower
than at the beginning. This means that having a long position in the contract during that month is not
profitable. The last price in March is $0.6792, so that the dollar value of the SFRs of the contract is
then $84,900. The net sum of the payments made by the long during the month of March is equal to
the difference between $86,350 and $84,900, namely $1,450.
Figure 5.4. provides the evolution of the margin account assuming that no withdrawals are
made and that the margin account earns no interest. In March 1999, the initial margin for the SFR
contract was $2,160 and the maintenance margin was $1,600. Three additional margin payments are
required when the account falls below the maintenance margin of $1,600. These margin payments are
of $827.5 on March 5, $712.5 on March 26, and finally $625 on March 30. The data used for the two
figures are reproduced in Table 5.2.
Chapter 5, page 34
Section 5.4. How to lose money with futures and forward contracts without meaning to.
In this section, we extend our analysis to consider several questions. First, we discuss the
pricing of futures and whether it differs from the pricing of forwards. Second, we evaluate whether
a difference between the futures price and the expected price of the deliverable asset or commodity
represents an arbitrage opportunity. Finally, we discuss the impact of financial market imperfections
on the pricing of forwards and futures.
Section 5.4.A. Pricing futures contracts.
If markingtomarket does not matter, there is no difference between a futures contract and
a forward contract in perfect markets as long as the margin can consist of marketable securities. This
is because, in this case, an investor can always deposit the margin with marketable securities so that
there is no opportunity cost of making the margin deposit. Traditionally, futures are treated like
forwards and the forward pricing results are used for futures. Treating futures like forwards for
pricing purposes provides a good first approximation, but one should be careful not to rely too much
on this approximation since it has some pitfalls.
If one treats futures like forwards, one is tempted to think that any difference between the
forward price and the futures price represents an arbitrage opportunity. Therefore, it is important to
examine this issue carefully. Suppose that a trader learns that the futures price for a contract maturing
in 90 days is higher than the forward price for a contract maturing on the same date with identical
delivery conditions. For instance, there are both forward contracts and futures contracts on the major
foreign currencies. At times, these contracts have identical maturities. With this example, one might
Chapter 5, page 35
be tempted to short the futures contract and take a long position in the forward contract. Surprisingly,
this strategy could lose money. Remember that there is a key difference between the forward contract
and the futures contract. With the forward contract, all of the gain or loss is paid at maturity. In
contrast, with the futures contract, the gains and losses are paid as they accrue.
We can always transform a futures contract into a contract with payoffs at maturity only
through reinvestment and borrowing. This transformation works as follows. As we make a gain, we
invest the gain in the riskfree asset until maturity. At maturity, we receive the gain plus an interest
payment. As we make a loss, we borrow to pay the loss and at maturity we have to pay for the loss
and for the cost of borrowing. The daily settlement feature of futures contracts affects the payoff at
maturity by magnifying both gains and losses through the interest payments.
In an efficient market, we do not know whether we will make gains or losses on the contract.
As a result, these possible gains and losses do not affect the futures price as long as interest rates are
constant and are the same for lending and borrowing. In this case, gains and losses are magnified in
the same way. Since we do not know whether we will gain or lose, the expected interest payments
are zero. Things get more complicated if interest rates change over time. Suppose that interest rates
are high when we make gains and low when we have to borrow because we make losses. In this case,
the reinvestment of gains makes us better off because the expected interest gain on investing profits
exceeds the expected interest loss in borrowing to cover losses on the futures position. Since, with
a forward contract, gains and losses are not paid when they accrue, we receive no interest payments
with the forward contract. If the reinvestment feature is advantageous to us, it must then be that the
futures price exceeds the forward price to offset the benefit of the reinvestment feature and make us
indifferent between a forward contract and a futures contract. The opposite occurs if the interest rate
Chapter 5, page 36
is higher when we have to borrow than when we get to lend. From our discussion, it is possible for
the futures price to exceed the forward price simply because interest rates are higher when the futures
buyer makes gains. If that is the case, taking a long position in the forward contract and a short
position in the futures contract does not make profits. It is a zero net present value transaction. In
fact, in this case, a long position in the forward contract and a short position in the futures contract
would make money if the forward price equals the futures price.
To make sure that we understand the impact of the daily settlement feature of futures
contracts on futures prices, lets look at a simple example that is also shown on Figure 5.5. Suppose
that we have three dates, 1, 2 and 3. The futures price at date 1 is $2. At date 2, it can be $1 or $3
with equal probability. At date 3, the futures price for immediate delivery is equal to the spot price
S and delivery takes place. Suppose first that the interest rate is constant, so that a oneperiod
discount bond costs $0.909. With this simple example, reinvestment of the proceeds takes place only
once, at date 2. At date 2, if the price is $1, the futures buyer has to pay $1 and borrow that amount.
In this case, the futures buyer has to repay 1/0.909 = 1.1 at date 3. Alternatively, if the price is $3,
the futures buyer receives $1. Investing $1 for one period yields $1.1 at date 3. Since the futures
buyer has a probability of 0.5 of gaining $0.1 through reinvestment and of losing that amount, there
is no expected benefit from reinvestment. Suppose next that the price of a oneperiod bond at date
2 is $0.893 if the futures price is $3 and $0.926 if the price is $1. The futures buyer gains $0.12 from
investing the gain (1/0.893 1) and loses $0.08 from paying interest on borrowing when the price is
$1. In this case, because the interest rate is higher when the futures buyer gains than when he loses,
there is an expected gain from reinvestment of $0.02 (0.5*0.12  0.5*0.08). The futures price has to
be higher than the forward price to insure that holding the futures contract does not have a positive
Chapter 5, page 37
net present value. Finally, if the price of the discount bond is $0.926 when the futures buyer makes
a profit and $0.893 when he makes a loss, the futures buyer loses from reinvestment since he receives
0.08 with probability 0.5 and has to pay 0.12 with the same probability. Therefore, the futures price
has to be lower than the forward price.
Keeping the futures price constant, the expected profits of the holder of a long futures
position increase when the correlation between interest rates and the futures price increases.
Consequently, for futures sellers to be willing to enter contracts where the futures price is positively
correlated with interest rates, the futures price of such contracts must be higher. Therefore, an
increase in the correlation between interest rates and futures prices results in an increase in the futures
price relative to the forward price. With this reasoning, one expects the futures price to exceed the
forward price when interest rates are positively correlated with the futures price. When interest rates
are negatively correlated with the futures price, the forward price should exceed the futures price.
A number of papers examine the relation between forward and futures prices. Some of these
papers focus on currencies and generally find only trivial differences between the two prices. In
contrast, studies that investigate the difference between forward and futures prices on fixed income
instruments generally find larger differences. This is not surprising in light of our theory since one
would expect the correlation between interest rates and the underlying instrument to be high in
absolute value for fixed income instruments. However, authors generally find that the theory
presented in this section cannot explain all of the difference, leaving a role for taxes and liquidity,
among other factors, in explaining it.
Section 5.4.B. The relation between the expected future spot price and the price for future
Chapter 5, page 38
delivery
Suppose that an investor expects the spot exchange rate for the SFR 90 days from now to be
at 74 cents and observes a forward contract price for delivery in 90 days of 70 cents. If the investor
is right, 90 days from now he can buy SFRs at 70 cents and he expects to resell them on the spot
market at 74 cents. Lets consider how we can understand this expected profit and whether markets
could be efficient with such an expected profit.
Note first that it could simply be that the investor is misinformed. In other words, the market
could be right and he could be wrong. In this case, the strategy would not produce an expected gain
if the investor knew what the market knows. Second, it could be that the market expects the spot rate
to be 70 cents and the investor is right. In this case, in expected value, the strategy would make a
profit. Remember, however, that there is substantial volatility to exchange rates, so that even though
the true expected spot rate is 74 cents, 90 days from now the actual exchange rate could turn out to
be 60 cents and the strategy would make a loss.
We now consider whether it is possible that the investor is right in his expectation of a spot
exchange rate of 74 cents and that the forward contract is correctly priced at 70 cents per SFR.
Taking a long forward position because one believes that the forward price is lower than what the
spot price will be when the contract matures is not an arbitrage position. This position can make
losses. It can also make larger gains than expected. We saw in chapter 2 that investors are rewarded
by the market for taking some risks. In particular, if the capital asset pricing model holds, investors
are rewarded for taking systematic risks. Suppose that a foreign currency has a beta of one. In this
case, bearing currency risk is like bearing market risk. The investor expects to be rewarded for
bearing this type of risk. An investor who has a long forward position is rewarded for bearing risk
Chapter 5, page 39
by a lower forward price. This increases the expected profit given the investors expectation of the
future spot price. Hence, going back to our example, if the investor expects the spot price to be at
74 cents but the forward price is at 70 cents, he makes an expected profit of four cents per DM when
he enters a forward contract he expects to hold to maturity. This expected profit is compensation for
bearing systematic risk. If a long forward position has a negative beta, then the forward price exceeds
the expected spot price because the short position has a positive beta and expects to be compensated
for bearing systematic risk.
A lot of research has been conducted to study the relation between forward prices, futures
prices, and expected spot prices. Most of this research has focused on the foreign exchange market.
The bottom line of this research is that if we average contracts over very long periods of time, the
forward price of these contracts on average equals the spot price at maturity. Hence, on average, the
forward price is the expected spot price. At the same time, this literature shows that typically a
forward contract on a currency for which interest rates are high is on average profitable. The two
findings are not contradictory: countries will sometime have high interest rates and other times low
interest rates. This means that at any point in time the forward price is unlikely to be equal to the
expected spot price. There is some evidence that shows that the current spot price is a better forecast
of the future spot price for major currencies than the forward exchange change rate.
Section 5.4.C. What if the forward price does not equal the theoretical forward price?
Throughout this chapter, we have made the assumption that markets are perfect. Suppose
now that there are some transaction costs. In this case, the forward price may not be equal to the
theoretical forward price. The reason is straightforward. Remember that at the theoretical forward
Chapter 5, page 40
price, in the absence of transaction costs, the cost of the replicating portfolio of the buyer is equal to
the cost of the replicating portfolio of the seller. In this case, if the forward price differs from its
theoretical value, either the buyer or the seller can construct an arbitrage portfolio that takes
advantage of the discrepancy. For instance, if the forward price is higher than its theoretical value,
it pays to sell forward and hedge the transaction by buying the deliverable asset and financing the
purchase with a loan that matures with the contract.
Suppose now that there are some transaction costs. Say that c
F
is the proportional transaction
cost for the forward contract (for instance, a commission that has to be paid to the broker), c
A
the
proportional transaction cost on purchasing the deliverable asset, and c
B
the proportional transaction
cost on borrowing. In this case, taking advantage of a forward price that is too high requires paying
transaction costs of c
F
F on the forward position, c
A
S(t) on purchasing the deliverable asset, and of
c
B
S(t) on borrowing. The total transaction costs for the long to hedge his position are therefore equal
to c
F
F + c
A
S(t) + c
B
S(t). Hence, if the difference between the forward price and its theoretical value
is positive, there is an arbitrage opportunity only if this difference exceeds the transaction costs of
going long the contract and hedging the position. Similarly, if the difference between the forward
price and its theoretical value is negative, this difference has to exceed the transaction cost of shorting
the contract and hedging the short position for there to exist an arbitrage opportunity.
With our reasoning, we can construct an expanded formula for the forward price. Let S
L
be
the sum of the transaction costs that have to be paid in forming an arbitrage portfolio that is long the
forward contract. Remember that such a portfolio involves a long forward position and a short
position in the replicating portfolio. Let S
S
be the sum of the transaction costs that have to be paid
in forming an arbitrage portfolio that is short the forward contract. Remember that an arbitrage
Chapter 5, page 41
S(t) 
P(t, t + i)
F
S(t) +
P(t, t + i)
L S
portfolio that is long the forward contract makes it possible to capture the value of the replicating
portfolio. To do that, one goes long the contract and short the replicating portfolio. One generates
a profit equal to the value of the replicating portfolio. Before transaction costs, the value of the
arbitrage portfolio must be less than the transaction costs required to create it. In this case, we must
have:
Forward price in the presence of transaction costs
(5.14.)
To check the formula, note it can be rewritten as:
S
S
# S(t)  P(t,t+i)F # S
L
If the forward price is lower than its theoretical value under perfect markets, then the term in the
middle is positive. Since transaction costs are positive, this means that the lefthand side inequality
is satisfied. If the righthand side inequality is not satisfied, then the costs of forming an arbitrage
portfolio are less than the profit from forming the arbitrage portfolio before transaction costs. If the
forward price is too high, the middle term is negative and one would like to short the forward
contract, using a long position in the replicating portfolio to hedge. To avoid arbitrage opportunities,
the gain from doing this has to be less than the transaction costs.
It is perfectly possible in the presence of real world frictions for the forward price (and the
Chapter 5, page 42
futures price by extension) to be different from the theoretical price that must hold if markets are
perfect. In some cases, the costs of forming arbitrage portfolios are minuscule so that one would
expect the discrepancies to be extremely small. One such case would be where one tries to arbitrage
forward price discrepancies for short standard maturity contracts on foreign exchange for major
currencies. Shortterm forward contracts for currencies have standard maturities of 30, 90, and 180
days. The transaction costs for arbitraging a tenyear foreign exchange forward contract would be
more significant. Whether the arbitrage costs are important or not depends on the liquidity of the
deliverable asset, on the trading expertise of the arbitrageur, and on the credit risk of the arbitrageur.
An AAA bank with an active trading room faces much lower transaction costs than a weakly
capitalized occasional participant in the foreign exchange market.
Section 5.5. Conclusion.
In this chapter, we learned how to price forward contracts. The key to pricing these contracts
is that they can be replicated by buying the underlying asset and financing the purchase until maturity
of the contract. Because of this, we can price the contracts by arbitrage. This means that we can price
a forward contract without having a clue as to the expected value of the underlying asset at maturity.
To price a forward contract on the SFR, we therefore do not need to know anything about exchange
rate dynamics. The forward price depends on the interest rate that has to be paid to finance the
purchase of the underlying asset, the cost to store it, and the benefit from holding it. As financing and
storage become more expensive, the forward price increases relative to the current price of the
underlying asset. As the benefit from holding the underlying asset increases, the forward price falls
relative to the price of the underlying asset. We then discussed how forward contracts can have
Chapter 5, page 43
substantial default risk and how futures contracts are similar to forward contracts with a builtin
mechanism to reduce and almost eliminate default risk. This mechanism is the daily settlement and
the posting of a margin. We then explained that the daily settlement allows participants in futures
markets to reinvest their gains. The futures price exceeds the forward price when this feature is
advantageous. We then discussed that forward and futures contracts may have systematic risk.
Systematic risk lowers the forward and futures prices to compensate the long for bearing the risk.
Finally, we showed how transaction costs can imply small deviations of forward prices from their
theoretical formula. The next step is to learn how to use forward and futures contracts for risk
management. We turn to this task in the next two chapters.
Chapter 5, page 44
Literature Note
The topics discussed in this chapter have generated an extremely large literature. Specialized
textbooks on futures, such as Duffie () or Siegel and Siegel () develop the material further and
provide references to the literature. Brennan (1986) and Kane (1980) have interesting theoretical
studies of the mechanisms used in futures markets to reduce counterparty risk. Melamed () provides
a good history of financial futures with a wealth of anecdotes. The comparison of futures and forward
is analyzed theoretically in Cox, Ingersoll, and Ross (1981) and Jarrow and Oldfield (1981). Richard
and Sundaresan (1981) provide a general equilibrium model of pricing of futures and forwards.
Routledge, Seppi, and Spatt (2000) derive forward prices when the constraint that inventories cannot
be negative is binding and show that this constraint plays an important role. When that constraint is
binding, spot has value that the forward does not have. Cornell and Reinganum (1981), French
(1983), Grinblatt and Jegadeesh (1996), and Meulbroek (1992) compare forwards and futures,
respectively, for currencies, copper, and Eurodeposits. Theoretical and empirical studies that
compare the future expected spot exchange rate and the forward exchange rate are numerous.
Hodrick reviews some of these studies for foreign exchange and Froot and Thaler (1990) provide an
analysis of this literature arguing that departures of the forward exchange rate from the future
expected spot exchange rate are too large to be consistent with efficient markets. For a recent study
of interest rate parity in the presence of transaction costs, see Rhee and Chang (1992). The Barings
debacle is chronicled in Rawnsley (1995).
Chapter 5, page 45
Key concepts
Forward contract, replicating portfolio, convenience yield, storage costs, futures contract, initial
margin, settlement variation, margin call, markingtomarket, cash delivery, physical delivery, price
limit, counterparty risk.
Chapter 5, page 46
Review questions
1. What is a forward contract?
2. What is the spot price?
3. What is a replicating portfolio for a forward contract?
4. What is required for the price of a forward contract to be such that there is an arbitrage
opportunity?
5. What is the impact of dividends on the forward price in a contract to buy a stock forward?
6. What is the convenience yield?
7. Why do storage costs matter in pricing forward contracts?
8. How do futures contracts differ from forward contracts?
9. What is the maintenance margin in a futures contract?
10. What is the difference between cash and physical delivery for a futures contract?
11. What happens if a price limit is hit?
12. Why would the futures price differ from the forward price when both contracts have the same
underlying and the same maturity?
13. Does the futures price equal the expected spot price at maturity of the futures contract?
14. Why would an arbitrage opportunity in perfect financial markets not be an arbitrage opportunity
in the presence of financial market imperfections?
Chapter 5, page 47
Problems
1. Suppose that on January 10, a oneyear defaultfree discount bond is available for $0.918329 per
dollar of face value and a twoyear defaultfree discount bond costs $0.836859 per dollar of face
value. Assuming that financial markets are perfect, suppose you want to own $1.5M face value of 1
year discount bonds in one year and you want to pay for them in one year a price you know today.
Design a portfolio strategy that achieves your objective without using a forward contract.
2. Using the data of question 1, suppose that you learn that the forward price of 1year discount
bonds to be delivered in one year is $0.912 per dollar of face value. What is the price today of a
portfolio that replicates a long position in the forward contract?
3. Using the replicating portfolio constructed in question 2, construct a strategy that creates arbitrage
profits given the forward price of $0.912. What should the forward price be so that you would not
be able to make arbitrage profits?
4. Suppose that you enter a long position in the forward contract at a price of $0.911285 per dollar
of face value for a total amount of face value of $1.5M. One month later, you find that the 11month
discount bond sells for $0.917757 and that the 23month discount bond sells for $0.829574. Compute
the value of your forward position at that point.
5. Given the prices of discount bonds given in question 4, how did the price of a oneyear discount
bond for delivery January 10 the following year change over the last month? Did you make money
Chapter 5, page 48
having a long forward position?
6. Consider a Treasury bond that pays coupon every six months of $6.5 per $100 of face value. The
bond matures in 10 years. Its current price is $95 per $100 of face value. You want to enter a forward
contract to sell that bond in two years. The last coupon was paid three months ago. The discount
bond prices for the next two years are: P(t,t+0.25) = 0.977508, P(t,t+0.5) = 0.955048, P(t,t+0.75)
0.932647, P(t,t+1) = 0.910328, P(t,t+1.25) = 0.888117, P(t,t+1.5) = 0.866034, P(t,t+1.75) =
0.844102, P(t,t+2) = 0.822341. Using these discount bond prices, find the forward price per dollar
of face value for a contract for the purchase of $100M of face value of the tenyear bond such that
the value of the replicating portfolio is zero.
7. Using the discount bond prices of question 6, price a forward contract on oil. The current price
per barrel is $18. The contract has maturity in one year. The inventory cost is 3% at a continuously
compounded rate. The convenience yield associated with having oil in inventory is 5% per year.
Given this, what is the forward price per barrel?
8. Consider the contract priced in question 7. Suppose that immediately after having entered the
contract, the convenience yield falls to 2%. How is the forward price affected assuming that nothing
else changes?
9. You are short the SFr. futures contract for five days. Lets assume that the initial margin is $2,000
and the maintenance margin is $1,500. The contract is for SFr. 100,000. The futures price at which
Chapter 5, page 49
you enter the contract at noon on Monday is $0.55. The Monday settlement price is $0.56. The
settlement prices for the next four days are $0.57, $0.60, $0.59, $0.63. You close your position on
Friday at the settlement price. Compute the settlement variation payment for each day of the week.
Show how your margin account evolves through the week. Will you have any margin calls? If yes,
for how much?
10. Suppose that on Monday at noon you see that the forward price for the SFr. for the same maturity
as the maturity of the futures contract is $0.57 and that you believe that the exchange rate is not
correlated with interest rate changes. Does this mean that there is an arbitrage opportunity? If not,
why not? Does it mean that there is a strategy that is expected to earn a riskadjusted profit but has
risk?
Chapter 5, page 50
Exhibit 5.1. Currency futures prices for March 1, 1999, published in the Wall Street Journal on
March 2, 1999.
Chapter 5, page 51
Table 5.1. Arbitrage trade when F = $0.99 per dollar of face value.
In this case, the replicating portfolio for a long forward position is worth $0.95  $0.969388*0.99
= $0.00969412. To exploit this, we short the contract and go long the replicating portfolio for a
long forward position. The third column shows the cash flow on March 1 and the fourth column
shows the cash flow on June 1.
Positions on March 1 Cash flow on
March 1
Cash flow on June 1
Short forward position 0 $0.99  P(June 1, August
30)
Replicating port
folio for long posi
tion
Long bill maturing
on August 30
$0.95 P(June 1, August 30)
Borrow present
value of F
$0.969388*0.99
= $0.959694
$0.99
Net cash flow $0.009694 0
Chapter 5, page 52
Table 5.2. Long SFR futures position during March 1999 in the June 1999
contract
Date Futures price
(F)
F*contract size Gain (Loss) Margin account add. deposit Margin account
(SFR125,000) (before add. de
posit)
(after add. de
posit)
3/1/99
0.6908
86,350.0
0
2,160.0
0
2,160.0
3/2/99
0.6932
86,650.0
300.0 2,460.0 0
2,460.0
3/3/99
0.6918
86,475.0
(175.0) 2,285.0 0
2,285.0
3/4/99
0.6877
85,962.5
(512.5) 1,772.5 0
1,772.5
3/5/99
0.6869
85,862.5
(100.0) 1,672.5 827.5
2,500.0
3/8/99
0.6904
86,300.0
437.5 2,937.5 0
2,937.5
3/9/99
0.6887
86,087.5
(212.5) 2,725.0 0
2,725.0
3/10/99
0.6919
86,487.5
400.0 3,125.0 0
3,125.0
3/11/99
0.6943
86,787.5
300.0 3,425.0 0
3,425.0
3/12/99
0.6883
86,037.5
(750.0) 2,675.0 0
2,675.0
3/15/99
0.6888
86,100.0
62.5 2,737.5 0
2,737.5
3/16/99
0.6944
86,800.0
700.0 3,437.5 0
3,437.5
3/17/99
0.6953
86,912.5
112.5 3,550.0 0
3,550.0
3/18/99
0.6918
86,475.0
(437.5) 3,112.5 0
3,112.5
3/19/99
0.6872
85,900.0
(575.0) 2,537.5 0
2,537.5
3/22/99
0.6897
86,212.5
312.5 2,850.0 0
2,850.0
3/23/99
0.6911
86,387.5
175.0 3,025.0 0
3,025.0
3/24/99
0.6891
86,137.5
(250.0) 2,775.0 0
2,775.0
3/25/99
0.6851
85,637.5
(500.0) 2,275.0 0
2,275.0
3/26/99
0.6812
85,150.0
(487.5) 1,787.5 712.5
2,500.0
3/29/99
0.6793
84,912.5
(237.5) 2,262.5 0
2,262.5
3/30/99
0.6762
84,525.0
(387.5) 1,875.0 625
2,500.0
3/31/99
0.6792
84,900.0
375.0 2,875.0 0
2,875.0
Source : The Wall Street Journal various issues (3/2/99 ~ 4/1/99)
Chapter 5, page 53
Exhibit 5.1
Wall Street Journal, March 1, 1999
Chapter 5, page 54
Figure 5.1. Timeline for long forward contract position
Chapter 5, page 55
Figure 5.2. Difference between the forward price and the spot price of the underlying good.
The term structure used for the example is the one used in Box 5.2. Figure for the home country.
Chapter 5, page 56
1000
800
600
400
200
0
200
400
600
800
1000
1 2 3 4 5 8 9 10111215161718192223242526293031
date
g
a
i
n
(
l
o
s
s
)
a
n
d
d
e
p
o
s
i
t
s

500.0
1,000.0
1,500.0
2,000.0
2,500.0
3,000.0
3,500.0
4,000.0
m
a
r
g
i
n
a
c
c
o
u
n
t
b
a
l
a
n
c
e
gain(loss)
deposits
balance
Figure 5.3. Margin account balance and margin deposits
Chapter 5, page 57
0.665
0.67
0.675
0.68
0.685
0.69
0.695
0.7
1 2 3 4 5 8 9 1011 1215161718 192223242526 293031
date
f
u
t
u
r
e
s
p
r
i
c
e
1000
800
600
400
200
0
200
400
600
800
g
a
i
n
(
l
o
s
s
)
futures price
gain(loss)
Figure 5.4. Daily gains and losses from a long futures position in the SFR in March 1999
Chapter 5, page 58
Figure 5.5. Marking to market and hedging.
To make a futures contract have payoffs only at maturity, one borrows markedtomarket losses and
invests markedtomarket gains. In this example, the futures price and the forward price are equal at
$2 at date 1. The futures price then falls to $1 at date 2 and stays there. Consequently, at date 3, the
spot price is $1. The payoff of the forward contract at date 3 is $1 for a long position. The payoff
for the futures contract is $1 at date 2. To make the futures contract have a payoff at date 3 only like
the forward contract, one can borrow $1 at date 2 which one repays at date 3. Hence, if the interest
rate is 10% for each period, one loses $1.1 with the futures contract at date 3 in this example.
Chapter 5, page 59
Box 5.1. Repos and borrowing using Treasury securities as collateral.
Typically, borrowing for those who hold inventories of Treasury securities is done in the repo market.
A repo is a transaction that involves a spot market sale of a security and the promise to repurchase
the security at a later day at a given price. One can therefore view a repo as a spot market sale of a
security with the simultaneous purchase of the security through a forward contract. A repo where the
repurchase takes place the next day is called an overnight repo. All repos with a maturity date in more
than one day are called term repos. A repo amounts to borrowing using the Treasury securities as
collateral. For this reason, rather than stating the price at which the underlying is bought back at a
later day, the contract states a rate that is applied to the spot price at origination to yield the
repurchase price. For instance, consider a situation where dealer Black has $100m worth of Treasury
securities that he has to finance overnight. He can do so using a repo as follows. He can turn to
another dealer, dealer White, who will quote a repo rate, say 5%, and a haircut. The haircut means
that, though White receives $100m of Treasury securities, he provides cash for only a fraction of
$100m. The haircut protects White against credit risk. The credit risk arises because the price of the
securities could fall. In this case, Black would have to pay more for the securities than they are worth.
If he could walk away from the deal, he would make a profit. However, since he has to pay for only
a fraction of the securities to get all of them back if there is a haircut, he will pay as long as the price
is below the promised payment by an amount smaller than the haircut. For instance, if the haircut is
1%, Black receives $100*(1/1.01) = $99.0099m in cash. The next day, he has to repay
$100*(1/1.01)*(1+0.05 /360 ) = $99.037m. Hence, if the securities had fallen in value to $99.05m,
Black would still buy them back. With this transaction, Black has funds for one day. Because this
transaction is a forward purchase, Black benefits if the price of the securities that are purchased at
maturity have an unexpectedly high value. With Treasury securities, therefore, the borrower benefits
if interest rates fall. Viewed from Whites perspective, the dealer who receives the securities, the
transaction is called a reverse repo. A reverse repo can be used to sell Treasury securities short in
the following way. After receiving the securities, the dealer can sell them. He then has to buy them
back to deliver them at maturity of the reverse repo. He therefore loses if the price of the securities
increases because he has to pay more for them than he receives when he delivers them at maturity.
Chapter 5, page 60
Box 5.2. Interest rate parity.
Suppose that an investor faces (continuously compounded) annual interest rates of 5% in the
U.S. and 1% in Switzerland for 90 days. He would like to know whether it is more advantageous to
invest in the U.S. or in Switzerland. The investment in Switzerland has exchange rate risk. One dollar
invested in SFRs might lose value because of a depreciation of the SFR. For instance, if the investor
invests $1m in Switzerland at the exchange rate of $0.7 per SFR, he might earn 1% p.a. on this
investment but exchange the SFRs into dollars in 90 days at an exchange rate of $0.8 per SFR. In this
case, he would gain 14.57% of his investment for an annualized rate of return of 54.41%!
This is because he gets 1/0.7 SFRs or SFR1.4286 initially that he invests at 1%, thereby having
SFR1.4321 at maturity (Exp[0.01*90/360]/0.7). He then converts his SFRs at $0.8, thereby obtaining
$1.1457 in 90 days. Hence, despite earning a lower interest rate in Switzerland than in the U.S., the
investor gains by investing in Switzerland. The exchange rate gain is an exchange rate return of 
53.41% (Ln[0.8/0.7]*360/90) measured at an annual continuously compounded rate. The total return
is the sum of the exchange rate return plus the interest earned, or 53.41% + 1% = 54.41%.
We know, however, that the investor could sell the proceeds of his SFR investment forward
at an exchange rate known today. Doing this, the investor is completely hedged against exchange
rate risk. He gets F*Exp[0.01*90/360]/0.7 for sure in 90 days, where F is the forward exchange rate,
irrespective of the spot exchange rate at that date. Consequently, F has to be such that investing at
the riskfree rate in the U.S. would yield the same amount as investing in SFRs and selling the
proceeds forward to obtain dollars. Lets define the annualized exchange rate return from buying
SFRs and selling them forward as the forward premium and use the notation f for this exchange rate
return. We use continuous compounding, so that for our example, the forward premium solves the
equation F = $0.7*Exp[f*90/360], so that we have f = Ln[F/0.7]*360/90. It must be the case, since
a hedged investment in SFRs is riskfree, that the return of this investment must equal 5% p.a. The
return of investing in SFRs is 1% + f. Hence, it must be that f = 4% computed annually. We can then
solve for the forward exchange rate such that 0.04 = Ln[F/0.7]*360/90. This gives us F = $0.7070.
The result that the foreign interest rate plus the forward premium must equal the domestic interest
rate to avoid arbitrage opportunities is called the interest rate parity theorem:
Interest rate parity theorem
When the domestic riskfree rate, the forward premium, and the foreign riskfree rate are for the same
maturity and continuous compounding is used, it must be true that:
Domestic riskfree rate = Forward premium + Foreign riskfree rate(IRPT)
The interest rate parity theorem states that, after hedging against foreign exchange risk, the riskfree
asset earns the same in each country. There is a considerable amount of empirical evidence on this
result. This evidence shows that most observed forward prices satisfy the interest rate parity theorem
if there are no foreign exchange controls and if transaction costs are taken into account. We discuss
the impact of transaction costs in the last section of this chapter.
The interest rate parity theorem as well as the result for the pricing of foreign exchange
forward contracts have a powerful implication. If one knows interest rates at home and in the foreign
country, we can compute the forward exchange rate. Alternatively, if one knows the forward
premium and the interest rates in one country, we can compute interest rates in the other country.
Chapter 5, page 61
Box 5.2. Figure shows graphically how one can do this. (Note that the result in equation (IRPT)
holds only approximately when one does not use continuouslycompounded returns.)
Chapter 5, page 62
Box 5.2. Figure. Term structures in the home and foreign country used to obtain the term
structure of forward premia.
The interest rate parity result states that the continuouslycompounded yield difference is equal to the
forward premium. Consequently, we can obtain the forward premium that holds in the absence of
arbitrage opportunities, whether a contract exists or not, if we know the yield difference.
Chapter 5, page 63
Box 5.3. The cheapest to deliver bond and the case of Fenwick Capital Management
The Chicago Board of Trade started trading the Tbond futures contract in August 1977. The
contract requires delivery of Tbonds with a face value at maturity of $100,000. To limit the
possibility of a successful corner, the contract defines the deliverable Tbonds broadly as longterm
U.S. Treasury bonds which, if callable, are not callable for at least 15 years or, if not callable, have
a maturity of at least 15 years. The problem with such a broad definition is that the short always
wants to deliver the bonds which are cheapest to deliver. This means that the short will find those
bonds with $100,000 face value that cost the least to acquire on the cash market. Without some price
adjustments to make the bonds more comparable, the bond with the longest maturity would generally
be the cheapest bond to deliver if interest rates have increased. This is because this bond will have a
low coupon for a long time to maturity so that it well sell at a low price compared to par. If the
supply of that bond is small, there could still be a successful short squeeze for that bond. Such a
squeeze might force the short to deliver other bonds than the one it would deliver without the
squeeze.
The exchange allows a great number of bonds to be deliverable, but makes these bonds
comparable through price adjustments. When a short delivers bonds, the amount of money the short
receives is called the invoice price. This invoice price is computed as follows. First, the settlement
futures price is determined. Second, this futures price is multiplied by a conversion factor. The
conversion factor is the price the delivered bond would have per dollar of face value if it were priced
to yield 8% compounded semiannually. Finally, the accrued interest to the delivery date is added to
this amount.
The use of the conversion factor is an attempt to make all deliverable bonds similar. This
works only imperfectly. The ideal method is one that would make the product of the futures price and
the conversion factor equal to the cash price of all deliverable bonds. This does not happen with the
method chosen by the exchange. At any point in time, there are bonds whose cash market price is
higher than their invoice price. Which bond is the cheapest to deliver depends on interest rates.
Typically, if interest rates are low, the cheapest to deliver bond will be a bond with a short maturity
or first call date because this bond will have the smallest premium over par. In contrast, if interest
rates are high, the cheapest bond to deliver will be a bond with a long maturity or first call date.
The futures price reflects the price of the cheapest bond to deliver. However, since there is
some uncertainty as to which bond will be the cheapest to deliver at maturity, the pricing issue is a
bit more complicated when interest rates are highly volatile. As a first step in pricing the Tbond
contract, however, one can use as the deliverable instrument the Tbond that is currently cheapest to
deliver. More precise pricing requires taking into account that the cheapest bond to deliver could
change over the life of the contract.
The Tnote market works in the same way as the Tbond market and offers a recent example
showing that one should not completely dismiss the risk of manipulation in these markets. In July
1996, the Commodity Futures Trading Commission fined Fenwick Capital Management for having
cornered the market of the cheapest to deliver note on the June 1993 contract. The cheapest to
deliver note was the February 2000 note with a coupon of 8.5%. Although the supply of that note
was initially of $10.7 billion, there had been a lot of stripping. Fenwick bought $1.4 billion of that
issue and had a long position in the Tnote contract of 12,700 contracts for $1.27 billion notional of
notes. In June 1993, it was very difficult to find the February 2000 note. Consequently, most shorts
had to deliver the nextcheapest note, an 8.875% May 2000 note. Delivering that note involved an
5
See The S.E.C. says it happened: A corner in the Treasury market by Floyd Norris,
The New York Times, July 11, 1996, page C6.
Chapter 5, page 64
extra cost of $156.25 a contract. Fenwick got that note delivered on 4,800 of its contracts. This
yielded a profit of $750,000.
5
Chapter 6: Risk measures and optimal hedges with forward and futures contracts
Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Section 6.1. Measuring risk: volatility, CaR, and VaR . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Section 6.2. Hedging in the absence of basis risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
1. The forward contract solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
2. The money market solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
3. The futures solution . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14
Section 6.3. Hedging when there is basis risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18
Section 6.3.1. The optimal hedge and regression analysis . . . . . . . . . . . . . . . . . 33
Section 6.3.2. The effectiveness of the hedge. . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Section 6.4. Implementing the minimumvariance hedge. . . . . . . . . . . . . . . . . . . . . . . . 41
Section 6.4.1. The relevance of contract maturity . . . . . . . . . . . . . . . . . . . . . . . 42
Section 6.4.2. Hedging with futures when the maturity of the contract is shorter
than the maturity of the exposure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46
Section 6.4.3. Basis risk, the hedge ratio, and contract maturity. . . . . . . . . . . . . 48
Section 6.4.4. Crosshedging. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Section 6.4.5. Imperfect markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Section 6.4.6. Imperfect divisibility. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Section 6.4.7. The multivariate normal increments model: Cash versus futures
prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
Section 6.5. Putting it all together in an example . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
1. Forward market hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
2. Money market hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
3. Futures hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
6.6. Summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Literature note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64
Questions and exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Figure 6.1. Relation between cash position and futures price when the futures price
changes are perfectly correlated with the cash position changes . . . . . . . . . . . . 67
Figure 6.2. Relation between cash position and futures price changes when the futures
price changes are imperfectly correlated with the cash position changes . . . . . . 68
Figure 6.3. Regression line obtained using data from Figure 6.2. . . . . . . . . . . . . . . . . . 69
Figure 6.4. This figure gives the SFR futures prices as of March 1, 1999 for three
maturities as well as the spot price . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Figure 6.5. Variance of hedged payoff as a function of hedge ratio and variance of basis
risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
Table 6.1. Market data for March 1, 1999 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Technical Box 6.1. Estimating Mean and Volatility . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Technical Box 6.2. Proof by example that tailing works . . . . . . . . . . . . . . . . . . . . . . . . 74
A) Futures hedge without tailing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
B) Futures hedge with tailing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75
Technical Box 6.3. Deriving the minimumvolatility hedge . . . . . . . . . . . . . . . . . . . . . . 76
Technical Box 6.4. The statistical foundations of the linear regression approach to
obtaining the minimumvariance hedge ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . 77
Chapter 6: Risk measures and optimal hedges with forward
and futures contracts
December 13, 1999
Ren M. Stulz 1998, 1999
Chapter 6, page 2
Chapter objectives
1. Measure risk of forward and futures positions.
2. Derive optimal hedges with forward and futures contracts when perfect hedge is possible.
3. Derive optimal hedges with futures contracts in the presence of basis risk.
4. Examine the implementation of optimal hedging strategies.
5. Review the practical obstacles to successful implementation of optimal hedging strategies.
Chapter 6, page 3
In this chapter, we investigate how to minimize risk using forward and futures contracts. A
simple example is as follows: suppose that a U.S. firm expects to receive 1 million Swiss Francs
(SFR1M) in three months. This cash flow is risky because the firm does not know what the exchange
rate of the dollar for the SFR will be in three months. Because of this receivable, firm cash flow in
three months is sensitive to changes in the dollar price of the SFR. The source of risk is the SFR
exchange rate. We call an identifiable source of risk a risk factor and a cash flows sensitivity to a
risk factor its exposure to that risk factor. Similarly, the sensitivity of the value of a position to a risk
factor is the exposure of that position to that risk factor. Here, an increase in the dollar price of the
SFR of x increases the firms cash flow in three months by 1M*x. Consequently, the firms exposure
to the dollar price of the SFR is 1M.
To choose its hedging policy with respect to its cash flow, the firm first has to measure the
cash flows risk and then figure out how much of that risk it wants to bear. In chapter 2, we saw that
individuals care about volatility risk. In chapter 4, we introduced value at risk (VaR) and cash flow
at risk (CaR) as risk measures for firms. In this chapter, we first show how to obtain volatility, CaR,
and VaR measures for a SFR exposure like the one described in the above paragraph. Since a long
forward position of SFR1M has the same exposure as this SFR cash flow, we also compute the risk
of such a position. In chapter 4, we discussed that a firm often finds increases in CaR or VaR to be
costly. We therefore consider optimal hedges of a foreign currency position when risk is measured
by volatility, CaR, and VaR. We first address the case where the firm can eliminate all risk resulting
from its SFR exposure. In this case, the optimal hedge eliminates all risk when such a hedge is feasible
and is costless. Hedging decisions are generally more complicated. This is especially the case when
no hedge eliminates all risk or when hedging costs are important. When hedging costs are
Chapter 6, page 4
unimportant but hedging cannot eliminate all risk, the firm has to find out which hedge minimizes risk.
We show how to find and implement this hedge. When hedging costs are important, the firm may
choose not to eliminate risk even though it can do so. In this case, the firms hedge depends on how
it trades off hedging costs and benefits. We address this problem in chapter 7.
Section 6.1. Measuring risk: volatility, CaR, and VaR.
Consider the simple situation where, on March 1, 1999, a firm expects to receive SFR1M in
three months. We assume for simplicity that there is no default risk on the part of the firms debtor,
so that there is no uncertainty as to whether the SFRs will be received. Further, interest rates are
assumed to be constant. The only uncertainty has to do with the dollar value of the SFRs when they
are received, which is our risk factor.
Lets call the firm Export Inc. and assume that it exported goods to Switzerland for which
it will receive SFR1M in three months. The SFR1M is the only cash flow of Export Inc. and the firm
will dissolve after receiving the SFRs. Suppose that the firm incurs a deadweight cost if the cash flow
is low. This could be the result of debt that the firm has to repay in three months, so that there might
be a bankruptcy cost if the firm defaults. We saw in chapter 4 that an appropriate risk measure in this
case is CaR. The CaR at the x% level is the cash flow shortfall relative to expected cash flow such
that the probability that the cash flow shortfall exceeds CaR is x%. To compute the CaR for Export
Inc., we need the probability distribution of the cash flow in three months.
Lets assume that the increments of the exchange rate are identically independently distributed
and that their distribution is normal. We use the abbreviation i.i.d to denote random variables that are
identically independently distributed. If increments are i.i.d, past increments provide no information
Chapter 6, page 5
about future increments. This means that a large increase in the exchange rate during one month
means nothing about the exchange rate change for the next month. With the assumption that
increments are i.i.d., we can estimate the mean and the variance of the increments. Technical Box
6.1. Estimating mean and volatility shows how to do this. Using monthly data for the dollar price
of the SFR, we obtain a mean monthly change of $0.000115 and a variance of 0.000631.
With our assumptions, the variance for each period is the same and the increments are
uncorrelated. To see what this implies for the variance over multiple future periods, lets look at the
variance of the exchange rate as of May 1 viewed from March 1. This is a twomonth interval to
make things easier to follow. The exchange rate on May 1 is the current exchange rate. Remember
that we denote a spot price by S. The spot price of the SFR, its exchange rate, on May 1 is S(March
1), plus the monthly increments, the change in March, )S(March), and the change in April,
)S(April). The variance of S(May 1) is therefore obtained as follows:
Var(S(May 1)) = Var(S(March 1) + )S(March) + )S(April))
= Var()S(March)) + Var()S(April)) + 2Cov()S(March), )S(April))
= Var()S(March)) + Var()S(April))
= 2Var()S(March))
The Var(S(March 1)) is equal to zero since we know the exchange rate on that day. We argued in
chapter 2 that assuming serially uncorrelated increments for financial prices is a good first assumption.
We therefore make this assumption here, so that Cov()S(March), )S(April)) = 0. Finally, we
assume that the distribution of each increment is the same, so that Var()S(March)) = Var()S(April)).
Chapter 6, page 6
The variance of the change in the exchange rate over 2 periods is twice the variance of the change
over one period. The same reasoning leads to the result that the variance of the exchange rate in N
periods is N times the variance of a oneperiod increment to the exchange rate. Since the volatility
is the square root of the variance, it follows that the volatility of the exchange rate over N periods is
/N times the volatility per period. This rule is called the square root rule for volatility:
Square root rule for volatility
If a random variable is identically independently distributed with volatility per period F, the volatility
of that random variable over N periods is F*/N.
This rule does not work if increments are correlated because, in that case, the variance of the sum of
the increments depends on the covariance between the increments.
Lets now look at an horizon of three months. The monthly volatility is the square root of
0.000631, which is 0.0251197. To get the threemonth volatility, we multiply the onemonth volatility
by the square root of three, 0.0251197*/3, which is 0.0435086. The volatility of the payoff to the
firm, the dollar payment in three months, is therefore 0.0435086*1M, or $43,508.6. The expected
change of the exchange rate over three months is three times the expected change over one month,
which is 3*(.000115) = 0.000345. Since the monthly exchange rate increment is normally
distributed, the sum of three monthly increments is normally distributed also because the sum of
normally distributed random variables is normally distributed. We know that with the normal
distribution, there is a probability of 0.05 that a random variable distributed normally will have a value
lower than its mean by 1.65 times its standard deviation. Using this result, there is a 0.05 probability
Chapter 6, page 7
that the exchange rate will be lower than its expected value by at least 1.65*0.0435086 = 0.0717892
per SFR. In terms of the overall position of Export Inc., there is a 0.05 probability that it will receive
an amount that is at least 0.0717892*1,000,000 = $71,789.2 below the expected amount. Suppose
that the current exchange rate is $0.75 and we use the distribution of the exchange rate we have just
estimated. In this case, the expected exchange rate is $0.75  $0.00325, or $0.7496550. The expected
cash flow is 1m*0.749655 = $749,655. As derived above, there is a 5% probability that the firms
cash flow shortfall relative to its expected value will exceed $71,789.2. Consequently, there is a 5%
chance that the cash flow will be lower than $749,655  $71,789.2, or $677,865.8. The CaR is
therefore $71,789.2. Lets suppose that the firm wants to have a 95% chance that its cash flow
exceeds $710,000. In this case, the firm has taken on too much risk because its target CaR is $39,655,
namely $749,655  $710,000.
We now consider a firm, Trading Inc., that has the same exposure measured but different
concerns. For simplicity, lets assume that interest rates are constant. This firm owns SFR Tbills with
face value of SFR1M that mature in three months so that, like Export Inc., it will receive SFR1M on
June 1. The exposure of Trading Inc. to the price of the SFR on June 1 is 1M. Because the firm has
limited capital, it has to finance c% of this position with a threemonth loan, so that a drop in the
value of the position by 1  c% before the firm can trade would make the firm insolvent. From the
previous chapter, we know that a position in SFR Tbills of SFR1M financed by selling short Tbills
in dollars maturing at the same date is the replicating portfolio for a long forward position to buy
SFR1M. Hence, the case where c% is equal to 100% corresponds to the case where Trading Inc. has
a long forward position. Such a firm cares about the value of its positions and the change in their
value over a short internal of time, say one day. If the position loses value over the next day, the firm
Chapter 6, page 8
can change the risks it takes. Suppose that the firm and its creditors are willing to tolerate at most
a 5% chance of insolvency. We saw in chapter 4 that such a firm would want to compute a VaR
measure.
To compute the VaR, one has to have the market value of the long SFR position. Because
the return of the US Tbill position is not random with constant interest rates, its value does not
matter for the VaR! The current exchange rate is $0.75 per SFR and the price of a 3month discount
bond in SFR is SFR0.96. In this case, the current dollar value of the SFR payoff is 0.75*0.96x1M =
$720,000. Over the next day, the expected change in the exchange rate is trivial and can be ignored.
The exposure of Trading Inc. to the price of the SFR tomorrow is 960,000, or 0.96*1M since an
increase in the price of the SFR tomorrow by x increases the value of the position of Trading Inc. by
960,000*x. To get the volatility of the exchange rate change over one day, we use the square root
rule. Lets use 21 trading days per month. This means that the volatility over one day is the square
root of 1/21 times the monthly volatility. We therefore have a daily exchange rate volatility given by
/(1/21)*0.0251107, which is 0.0054816. If it were to liquidate the position today, Trading Inc.
would get SFR960,000, which it then multiplies by the exchange rate to get the dollar value of the
position. The daily dollar volatility is therefore 960,000*0.0054816 = $5,262.3. Lets assume that the
daily change in the dollar price of the SFR is normally distributed. There is therefore a 5% chance that
the position will lose at least 1.65*5,262.3 = $8,683.
Remember that Trading Inc. finances c% of its position at inception. Suppose that c% is equal
to 99.5%. In this case, Trading Inc. has equity on March 1 corresponding to 0.005*$720,000. This
amounts to $3,600. Consequently, if the VaR is $8,683, there is more than a 5% chance that the
equity of Trading Inc. could be wiped out in one day. This means that Trading Inc. has more risk than
Chapter 6, page 9
it wants. It can reduce that risk by scaling down its position, by hedging, or by increasing its equity
so that it requires less financing. In this chapter, we focus on hedging as a way to solve this problem.
Note again that, because the return of the short U.S. Tbill position is nonstochastic, it does not affect
the VaR. Consequently, the VaR of Trading Inc. is the same whether it finances all or nothing of its
position in SFR Tbills. Hence, even though a forward contract has no value at inception, it has a
positive VaR because there is a risk of loss. In this case, a forward contract to buy SFR1M on June
1 has a daily VaR of $8,683.
Lets go back to our formula for the replicating portfolio of a forward contract to check that
we computed the VaR correctly. Remember that the value of the forward contract at inception is
equal to the present value of SFR Tbills with face value equal to the amount of SFR bought forward
minus the present value of US Tbills with same maturity for a present value equal to the present
value of the forward price per SFR times the amount of SFR bought forward:
Value of forward at inception = S(March 1)*P
SFR
(June 1)*1M  F*P(June 1)*1M
where P(June 1) (P
SFR
(June 1)) is the March 1 value of a discount bond that pays $1 (SFR1) on June
1. The only random variable in this expression is the spot exchange rate. Hence, the volatility of the
change in value is:
Volatility of one day change in value =
Vol[S(March 2)*P
SFR
(March 2, June 1)*1M  S(March 1)*P
SFR
(June 1)*1M] =
P
SFR
(June 1)*Vol[One day change in spot exchange rate]*1M
Chapter 6, page 10
where P
SFR
(March 2, June 1) is the March 2 price of a discount bond that pays SFR1 on June 1. We
neglect the change in value of the discount bond over one day in the last line since it is small. Since
the change in the exchange rate is normally distributed, the VaR of the forward contract is 1.65 times
the volatility of the change in value of the position.
Both Export Inc. and Trading Inc. have taken on too much risk. In the case of Export Inc.,
the CaR over three months is computed as:
Cash flow at risk over three months =
1.65*Cash flow volatility =
1.65*Exchange rate change volatility over three months*1M
= 1.65*0.00435086*1M
= $71,789.2
In the case of Trading Inc., the relevant measure of risk is VaR over one day and it is computed as:
Value at Risk over one day
= 1.65*Volatility of value of position over one day
= 1.65*Exchange rate volatility over one day*SFR value of position
= 1.65*0.0054816*960,000
= $8,683
In this case, both CaR and VaR depend on the exchange rate volatility linearly. If the exchange rate
1
The proof is straightforward. The payoff is Constant*Risk factor. The volatility of the
payoff is Constant*Volatility of risk factor. For CaR, the payoff is cash flow, so that the CaR is
1.65*Constant*Volatility of risk factor. For VaR, we have that the VaR is
1.65*Constant*Volatility of risk factor. In all three cases, the risk measure is a constant times the
volatility of the risk factor.
Chapter 6, page 11
volatility doubles, VaR and CaR double. This is because the only source of risk for both firms is the
price of the SFR. This exposure is fixed in that the firms receive a fixed amount of SFRs at a future
date. We call the price of the SFR the risk factor for our analysis. Whenever the exposure is a
constant times the risk factor and the distribution of the risk factor is normal, volatility, CaR, and VaR
depend linearly on the volatility of the risk factor.
1
Section 6.2. Hedging in the absence of basis risk.
Consider now the situation of Export Inc. and Trading Inc. These firms have to figure out
how to reduce their risk because they have taken on too much risk. In this section, we explore how
these firms can eliminate risk using the forward market, the money market, and the futures market:
1. The forward contract solution. Suppose that Export Inc. sells its exposure to the risk
factor, SFR1M, forward on March 1. Lets simplify our notation and denote the forward price today
on a forward contract that matures in three months by F. The forward contract is a derivative that
pays F  S(June 1) per unit of SFR sold forward, so that Export Inc. will have on June 1:
Cash position + payoff of forward position =
S(June 1)*1M + [F*1M  S(June 1)*1M] = F*1M
Since the forward price is known today, there is no risk to the hedged position as long as there is no
Chapter 6, page 12
counterparty risk with the forward contract. In the absence of counterparty risk, the dollar present
value of the hedged SFRs is P(June 1)*F*1M. We define a hedge to be a short position in a hedging
instrument put on to reduce the risk resulting from the exposure to a risk factor. Here, the hedge is
SFR1M since we go short SFR1M on the forward market. We can also compute the hedge for a one
unit exposure to a risk factor. Computed this way, the hedge is called the hedge ratio. In our
example, the hedge ratio is one because the firm goes short one SFR forward for each SFR of
exposure.
Consider now the impact of a forward hedge on our risk measures. We can compute the
volatility of the hedged payoff. When the firm goes short SFR1M forward for delivery on June 1 at
a price of F per unit, the volatility of the hedged payoff is equal to zero:
Volatility of hedged payoff = Vol($ value of SFR payment  Forward position payoff)
= Vol(S(June 1)*1M  (S(June 1)  F)*1M)
= Vol(F)
= 0
Since the hedged payoff is the hedged cash flow, going short the exposure makes the CaR equal to
zero:
CaR of hedged payoff = 1.65*Vol(Hedged payoff)
= 0
Chapter 6, page 13
Further, since the value of the position is the present value of the hedged payoff, this hedge makes
the VaR equal to zero:
VaR of hedged position = 1.65*Vol(PV(Hedged payoff))
= 1.65*Vol(P(June 1)*F*1M)
= 0
In the context of this example, therefore, the same hedge makes all three risk measures equal to zero.
This is because all three risk measures depend linearly on the volatility of the same risk factor when
the risk factor has a normal distribution.
Though a threemonth forward contract eliminates all risk for Trading Inc., Trading Inc. cares
only about the risk over the next day. With constant SFR interest rates, Trading Inc. has a
nonstochastic exposure of SFR960,000 tomorrow. Consequently, a oneday forward contract
eliminates all risk over that day also. This means that if Trading Inc. goes short SFR960,000 on the
forward market, its oneday VaR becomes zero. With perfect financial markets, it does not matter
which solution Trading Inc. chooses since both solutions achieve the same objective of eliminating
the oneday VaR risk and no transaction costs are involved. If SFR interest rates are random, the
exposure tomorrow is random because the present value of SFR1M to be paid on June 1 is random
while the exposure on June 1 is certain. In this case, the threemonth forward contract eliminates all
risk for Trading Inc. while the oneday forward contract does not. We address the issue of hedging
a random exposure in chapter 8.
It is important to understand that using a succession of oneday forward contracts cannot
Chapter 6, page 14
make the CaR of Export Inc. equal to zero if interest rates change randomly over time. This is
because, in this case, the oneday forward exchange rate is not a deterministic fraction of the spot
exchange rate. For instance, if the SFR interest rate increases unexpectedly, the forward exchange
rate falls in relation to the spot exchange rate. Consequently, the amount of dollars Export Inc. would
receive on June 1 using oneday forward contracts would be random, since it would depend on the
evolution of interest rates between March 1 and June 1.
2. The money market solution. We know that there is a strategy that replicates the forward
contract with money market instruments. In three months, Export Inc. receives SFR1M. The firm
could borrow in SFR the present value of SFR1m to be paid in 90 days. In this case, Export Inc. gets
today P
SFR
(June 1)*1M in SFRs. These SFRs can be exchanged for dollars at todays spot exchange
rate, S(March 1). This gives Export Inc. S(March 1)*P
SFR
(June 1)*1m dollars today. We know from
the forward pricing formula that S(March 1)*P
SFR
(June 1) is equal to P(June 1)*F if the forward
contract is priced so that there are no arbitrage opportunities.
3. The futures solution. Suppose that there is a futures contract that matures on June 1. In
this case, the futures contracts maturity exactly matches the maturity of the SFR exposure of Export
Inc. In the absence of counterparty risk, going short the exposure eliminates all risk with the forward
contract. This is not the case with the futures contract. Remember that futures contracts have a daily
settlement feature, so that the firm receives gains and losses throughout the life of the contract. In
chapter 5, we saw that we can transform a futures contract into the equivalent of a forward contract
by reinvesting the gains at the riskfree rate whenever they occur and borrowing the losses at the risk
free rate as well. The appropriate riskfree rate is the rate paid on a discount bond from when the gain
or loss takes place to the maturity of the contract. Since a gain or loss made today is magnified by
Chapter 6, page 15
the interest earned, we need to adjust our position for this magnification effect. Lets assume that
interest rates are constant for simplicity. A gain (loss) incurred over the first day of the futures
position can be invested (borrowed) on March 2 until June 1 if one wants to use on June 1 to offset
a loss (gain) on the cash position at that date. This means that over the next day the firm has to only
make the present value of the gain or loss that it requires on June 1 to be perfectly hedged. Therefore,
the futures position on March 1 has to be a short position of SFR 1M*P(June 1).
Remember that $1 invested in the discount bond on March 1 becomes 1/P(June 1) dollars on
June 1. Any dollar gained on March 1 can be invested until June 1 when the gain made the first day
plus the interest income on that gain will correspond to what the gain would have been on a futures
position of SFR1M:
Gain on June 1 from change in value of futures position on March 1
= Change in value of futures position on March 1/P(June 1)
= P(June)*1M*Change in futures price of 1 SFR on March 1/P(June 1)
= Change in futures price of 1 SFR on March 1*1M
This change in the hedge to account for the marking to market of futures contracts is called tailing
the hedge. Remember that the forward hedge is equal to the exposure to the risk factor. To obtain
the futures hedge, we have to take into account the markingtomarket of futures contracts by tailing
the hedge. To tail the hedge, we multiply the forward hedge on each hedging day by the present value
on the next day (when settlement takes place) of a dollar to be paid at maturity of the hedge. The
tailed hedge ratio for a futures contract is less than one when the hedge ratio for a forward contract
Chapter 6, page 16
is one. Remember from the chapter 5 that the March 1 price of a Tbill that matures on June 1 is
$0.969388. Therefore, the tailed hedge consists of selling short SFR969,388 for June 1 even though
the exposure to the SFR on June 1 is SFR1M. Note now that on the next day, March 2, the gain on
the futures position can only be invested from March 3 onwards. Hence, tailing the hedge on March
2 involves multiplying the exposure by the present value on March 3 of a dollar to be paid on June
1. This means that the tailed hedge changes over time. For constant interest rates, the tailed hedge
increases over time to reach the exposure at maturity of the hedge. With this procedure, the sum of
the gains and losses brought forward to the maturity of the hedge is equal to the change in the futures
price between the time one enters the hedge and the maturity of the hedge. Technical Box 6.2. Proof
by example that tailing works provides an example showing that this is indeed the case.
Through tailing, we succeed in using a futures contract to create a perfect hedge. Tailing is
often neglected in practice. Our analysis makes it straightforward to understand when ignoring tailing
can lead to a large hedging error. Consider a hedge with a short maturity. In this case, the present
value of a dollar to be paid at maturity of the hedge is close to $1. Hence, tailing does not affect the
hedge much and is not an important issue. Consider next a situation where a firm hedges an exposure
that has a long maturity. Say that the firm wants to hedge a cash flow that it receives in ten years. In
this case, the present value of a dollar to be paid at maturity of the hedge might be fifty cents on the
dollar, so that the optimal hedge would be half the hedge one would use without tailing. With a hedge
ratio of one, the firm would effectively be hedging more exposure than it has. This is called over
hedging.
Lets consider an example where overhedging occurs. Suppose that Export Inc. receives the
SFR1M in ten years and does not tail the hedge. Lets assume that the futures price is the same as the
Chapter 6, page 17
tenyear forward price on March 1, which we take to be $0.75 for the sake of illustration, and that
the present value of $1 to be received in ten years is $0.50. Consider the hypothetical scenario where
the SFR futures price increases tomorrow by 10 cents and stays there for the next ten years. Without
tailing the hedge, Export Inc. goes short SFR1M on the futures market. In ten years, Export Inc. will
receive $850,000 by selling SFR1M on the cash market. However, it will have incurred a loss of 10
cents per SFR on its short futures position of SFR1M after one day. If Export Inc. borrows to pay
for the loss, in ten years it has to pay 0.10*1M*(1/0.50), or $200,000. Hence, by selling short
SFR1M, Export Inc. will receive from its hedged position $850,000 minus $200,000, or $650,000,
in comparison to a forward hedge where it would receive $750,000 in ten years for sure. This is
because its futures hedge is too large. The tailed hedge of 0.5*SFR1M would have been just right.
With that hedge, Export Inc. would receive $750,000 in ten years corresponding to $850,000 on the
cash position minus a loss of $100,000 on the futures position (an immediate loss of $50,000 which
amounts to a loss of $100,000 in ten years). The greater the exchange rate at maturity, the greater
the loss of Export Inc. if it goes short and fails to tail its hedge. Hence, the position in futures that
exceeds the tailed hedge Export Inc. should have represents a speculative position. Overhedging
when one is long in the cash market amounts to taking a short speculative position.
Note that in addition to affecting the size of the position, the markingtomarket feature of
the futures contract creates cash flow requirements during the life of the hedge. With a forward
hedge, no money changes hands until maturity of the hedge. Not so with the futures hedge. With the
futures hedge, money changes hands whenever the futures price changes. One must therefore be in
a position to make payments when required to do so. We will talk more about this issue in the next
chapter.
Chapter 6, page 18
The position in the futures contract maturing on June 1 chosen by Export Inc. would eliminate
the risk of Trading Inc. also. With constant interest rates, a position in a futures contract maturing
tomorrow would also eliminate the VaR risk of Trading Inc. for the same reason that a position in
a oneday forward contract would eliminate the VaR risk of Trading Inc. There is no difference
between a futures contract that has one day to maturity and a oneday forward contract.
Section 6.3. Hedging when there is basis risk.
We assumed so far that the SFR futures contract matures when Export Inc. receives the SFR
cash payment. Remember that if the contract matures when Export Inc. receives the SFRs, the futures
price equals the spot price on that date. This is no longer true if the futures contract does not mature
on June 1. Suppose that there is no contract maturing on June 1 available to Export Inc., so that it
uses a futures contract maturing in August instead. With this contract, Export Inc. closes the futures
position on June 1. Since Export Inc. receives the cash payment it hedges on June 1, the adjustment
factor for tailing the hedge is the price of a discount bond that matures on June 1, the maturity date
of the hedge, and not the price of a discount bond that matures when the futures contract matures.
In this case, assuming a tailed hedge, the payoff of the hedged position on June 1 is:
Payoff of cash position + Payoff of hedge
= 1M*S(June 1)  1M*[G(June 1)  G(March 1)]
= 1M*G(March 1) + 1M*{e(June 1)  G(June 1)}
where G(March 1) is the futures price when the position is opened on March 1. The term in curly
2
This is called more precisely the spotfutures basis. Authors also sometimes call the basis
the difference between the futures price and the spot price, which is called the futuresspot basis.
Chapter 6, page 19
brackets is the basis on June 1. The basis is usually defined as the difference between the spot price
and the futures price on a given date.
2
There is basis risk if the value of the cash position at maturity
of the hedge is not a deterministic function of the futures price at maturity. With our example, there
would be no basis risk if the futures contract were to mature when Export Inc. receives the SFR1M
since, in that case, the term in curly brackets is identically equal to zero and the value of the cash
position is the futures price times 1M. The lack of a contract with the right maturity is not the only
reason for the existence of basis risk, however. Suppose that, for the sake of illustration, there is no
SFR contract available and that Export Inc. has to use a Euro futures contract instead. The futures
strategy would have basis risk in this case even if the Euro contract matures when Export Inc.
receives the SFRs since on that date the difference between the price of the Euro and the price of the
SFR is random. Consequently, a hedge can have basis risk because the available contract has the
wrong maturity or the wrong deliverable good.
We will now show that when the spot price is a constant plus a fixed multiple of the futures
price, a perfect hedge can be created. In this case, the basis is known if the futures price is known.
The method used to find the hedge when the spot price is a linear function of the futures price will
be useful when there is basis risk also. Lets assume that the futures price and the spot exchange rate
are tied together so that for any change in the futures price of x, the spot exchange rate changes
exactly by 0.9*x. This means that if we know the change in the futures price from March 1 to June
1, we also know the change in the spot exchange rate and, hence, we know the change in the basis
(it is 0.1x since the change in the basis is the change in the spot exchange rate minus the change in
Chapter 6, page 20
the futures price).
To eliminate the risk caused by its exposure to the SFR, Export Inc. wants a hedge so that
the firm is unaffected by surprises concerning the SFR exchange rate. This means that it wants the
unexpected change in the value of its futures position to offset exactly the unexpected change in the
value of its cash market position. The value of Export Inc.s cash market position on June 1 is
SFR1M*S(June 1). With our assumption about the relation between the futures price and the spot
exchange rate, an unexpected change of x in the futures price is associated with a change in the value
of the cash position of SFR1M*0.9*x. The exposure of the cash position to the futures price is
therefore SFR futures 1M*0.9, or SFR futures 900,000, since a change in the futures price of x is
multiplied by 900,000 to yield the change in the cash position. Another way to put this is that the
change in value of the cash position is exactly equivalent to the change in value of a futures position
of SFR900,000. Suppose that Export Inc. goes short h SFRs on the futures market. In that case, the
impact of an unexpected change in the futures price of x and of the associated change in the spot
exchange rate of 0.9*x on the value of its hedged position is equal to the impact of the spot exchange
rate change on the cash position, 0.9*1M*x, minus the impact of the change in the futures price on
the value of the futures position,  h*x. For h to eliminate the risk associated with Export Inc.s
exposure to the SFR, it has to be that 0.9*1M*x  h*x is equal to zero irrespective of the value of x.
Consequently, h has to be equal to a short futures position of SFR900,000. With h = 900,000, we
have:
Unexpected change in payoff of hedged position
= 0.9*1M*x  h*x = 0.9*1M*x  900,000*x = 0
Chapter 6, page 21
With h = 900,000, the volatility of the payoff of the hedged position is zero, so that a short futures
position equal to the exposure of the cash position to the futures price is the volatilityminimizing
hedge. Since the exposure of Export Inc. to the futures price is 900,000, Export Inc. goes short
SFR900,000 futures. Had Export Inc. gone short its exposures to the risk factor instead of its
exposure to the futures price, a change in the futures price of x would change the cash market
position by 0.9*1M*x dollars and would change the futures position by 1M*x dollars, so that the
value of the hedged position would change by 0.1*1M*x dollars. Hence, if the firm went short its
exposure to the risk factor on the futures market, the value of its hedged position would depend on
the futures price and would be risky. In contrast, the hedged position has no risk if the firm goes short
its exposure to the futures price.
In the absence of basis risk, we can go short a futures contract whose payoff is perfectly
correlated with the risk factor, so that the optimal hedge is to go short the exposure to the risk factor
as we saw in the previous section. In the presence of basis risk, we cannot go short the risk factor
because we have no hedging instrument whose payoff is exactly equal to the payoff of the risk factor.
In our example, the risk factor is the SFR on June 1, but we have no way to sell short the SFR on
June 1. Consequently, we have to do the next best thing, which here works perfectly. Instead of going
short our exposure to the risk factor, we go short our exposure to the hedging instrument we can use.
Here, the hedging instrument is the futures contract. Our exposure to the futures price is SFR900,000
in contrast to our exposure to the risk factor which is SFR1M. Since we are using the futures contract
to hedge, the best hedge is the one that makes our hedged position have an exposure of zero to the
futures price. If the exposure of the hedged position to the futures price were different from zero, we
would have risk that we could hedge since our hedged position would depend on the futures price.
Chapter 6, page 22
In the above analysis, the optimal hedge is equal to the hedge ratio, which is the futures hedge
per unit of exposure to the risk factor, 0.9, times the exposure to the risk factor, 1M, or a short
futures position of SFR900,000. Suppose the exposure to the risk factor had been SFR100M instead.
In this case, the hedge would have been h = 0.9*100M, or a short position of SFR90M. Generally,
for a given exposure to a risk factor, the hedge is the hedge ratio times the exposure. The hedge ratio
would be the same for any firm hedging an SFR exposure in the same circumstances as Export Inc.
even though each firm would have a different hedge because the size of its exposure would be
different. In other words, if there was another firm with an exposure of 100M, that firm could use the
same hedge ratio as Export Inc., but its hedge would be a short SFR futures position of 0.9*100M.
The hedge can be computed as the product of the hedge ratio and the exposure to the risk factor
whenever the exposure to the risk factor is known with certainty at the start of the hedging period.
Here, the firm knows how many SFRs it will receive on June 1. In this chapter, we assume the
exposure to the risk factor is known with certainty. We can therefore compute the hedge ratio and
then multiply it by the exposure to get the actual hedge. To compute the hedge ratio, we have to
analyze the relation between the changes in the spot exchange rate and the futures price since the
hedge ratio is the exposure to the futures price of one unit of exposure to the risk factor, but we can
ignore the size of the firms exposure to the spot exchange rate.
Suppose that the relation in the past between changes in the spot exchange rate and changes
in the futures price over periods of same length as the hedging period is the same as what it is
expected to be during the hedging period. We can then plot past changes in the spot exchange rate
against past changes in the futures price. For simplicity, we assume that these changes have an
expected value of zero, so that they are also unexpected changes. If their expected value is not zero,
3
We are therefore assuming a linear relation between changes in the spot exchange rate
and the futures price. The relation does not have to be linear. For instance, the basis could be
smaller on average when the futures price is high. We will see later how the analysis is affected
when the relation is not linear, but in this chapter we stick to a linear relation.
Chapter 6, page 23
these changes can be transformed into unexpected changes by subtracting their expected value. If
there is an exact linear relation between these changes, the plot would look like it does in Figure 6.1.
Figure 6.1. shows the case where the spot exchange rate changes by 0.9x for each change in the
futures price of x. (The plot uses simulated data which satisfy the conditions of our example.)
Because the change in the spot exchange rate is always 0.9 times the change in the futures price, all
the points representing past observations of these changes plot on a straight line.
With basis risk, things are more complicated since the change in the futures price is randomly
related to the change in the spot exchange rate. Lets assume again that the distribution of changes
in the spot exchange rate and the futures price is the same in the past as it will be over the hedging
period. We assume that the futures contract is the only hedging instrument available. Suppose,
however, that the relation that holds exactly in Figure 6.1. no longer holds exactly. Instead of having
past observations plot along a straight line as in Figure 6.1., they now plot randomly around a
hypothetical straight line with a slope of 0.9 as shown in Figure 6.2. (using simulated data). It is
assumed that for each realization of the change in the futures price, the change in the spot exchange
rate is 0.9 times that realization plus a random error that is not correlated with the futures price.
3
This
random error corresponds to the basis risk with our assumptions, since it is the only source of
uncertainty in the relation between the spot exchange rate and the futures price.
With our change in assumptions about the relation between the spot price and the futures
price, we can no longer know for sure what the spot price will be given the futures price as we could
Chapter 6, page 24
with our example in Figure 1. The best we can do is to forecast the spot price assuming we know the
futures price. Since the spot price is 0.9 times the futures price plus noise that cannot be forecasted,
our best forecast of the exposure of Export Inc. to the futures price is 0.9*1M, or 0.9 per unit of
exposure to the risk factor. In this case, 0.9*1M is our forecasted exposure to the futures price.
Export Inc.s volatilityminimizing hedge is to go short the forecasted exposure to the hedging
instrument because with this hedge the unexpected change in the cash position is expected to be equal
to the unexpected change in the futures position plus a random error that cannot be predicted and
hence cannot affect the hedge. If the futures price changes unexpectedly by x, the expected change
in the value of the cash position of Export Inc. per unit exposure to the risk factor is 0.9*x plus the
random error unrelated to the futures price. The expected value of the random error is zero, so that
the futures gain of 0.9*x is expected to offset the cash position loss per SFR but does so exactly only
when the random error is zero.
Lets now examine why, in the presence of basis risk, we cannot find a hedge that decreases
the volatility of the hedged cash flow more than a hedge equal to the forecasted exposure of the cash
position to the futures price. We assume that Export Inc. knows the forecasted exposure of the spot
exchange rate to the futures price. Let )S be the change in the spot exchange rate and )G be the
change in the futures price over the hedging period. The hedged cash flow per SFR is therefore:
Hedged cash flow
= Cash market position on March 1 + Change in value of cash position + Hedge position payoff
= S(March 1) + [S(June 1)  S(March 1)]  h*[G(June 1)  G(March 1)]
= S(March 1) + )S  h*)G
Chapter 6, page 25
We know, however, that the change in the cash market position per SFR is forecasted to be 0.9 times
the change in the futures price. Using this relation, we get the following expression for the hedged
cash flow per unit of exposure to the SFR:
Hedged cash flow when forecasted exposure of SFR to futures price is 0.9
= 0.9*)G + Random Error  h*)G + S(March 1)
= (0.9  h)*)G + Random Error + S(March 1)
Consequently, the hedged cash flow is risky for two reasons when the forecasted exposure of the cash
position to the futures price is known. If the hedge differs from the forecasted exposure, the hedged
cash flow is risky because the futures price is random. This is the first term of the last line of the
equation. Irrespective of the hedge, the hedged cash flow is risky because of the random error which
represents the basis risk. To get the volatility of a sum of random variables, we have to take the
square root of the variance of the sum of random variables. With this argument, therefore, the
volatility of the hedged cash flow per unit exposure to the SFR is:
Volatility of hedged cash flow per unit exposure to the SFR
= {(0.9  h)
2
*Var()G) + Var(Random Error)}
0.5
Remember that the volatility of k times a random variable is k times the volatility of the random
variable. Consequently, the volatility of Export Inc.s hedged cash flow is simply 1M times the
volatility of the hedged cash flow per unit of SFR exposure. There is no covariance term in the
Chapter 6, page 26
expression for the volatility of the hedged cash flow because the random error is uncorrelated with
the change in the futures price, so that the two sources of risk are uncorrelated. Setting the hedge
equal to the expected exposure to the futures price of 0.9*1M, we eliminate the impact of the
volatility of the futures price on the volatility of the hedged cash flow. There is nothing we can do
about the random error with our assumptions, so that the volatility of hedged cash flow when the
hedge is 0.9*1M is minimized and is equal to the volatility of the random error. Hence, going short
the forecasted exposure to the hedging instrument is the volatilityminimizing hedge ratio.
So far, we assumed that Export Inc. knows the forecasted exposure of the risk factor to the
hedging instrument. Suppose instead and more realistically that it does not know this forecasted
exposure but has to figure it out. All Export Inc has available is the information contained in Figure
6.2. In other words, it knows that the distribution of past changes in the spot exchange rate and the
futures price is the same as the distribution of these changes over the hedging period and has a
database of past observations of these changes. Therefore, Export Inc. must use the data from Figure
6.2. to find the optimal hedge.
To minimize the volatility of its hedged cash flow, Export Inc. wants to find a position in
futures such that the unexpected change in value of that position matches the unexpected change in
value of its cash position as closely as possible. (Remember that expected changes, if they differ from
zero, do not contribute to risk, so that to minimize risk one has to offset the impact of unexpected
changes in the cash position.) This turns out to be a forecasting problem, but not the usual one. The
usual forecasting problem would be one where, on March 1, Export Inc. would try to forecast the
change in the futures price and the change in the value of the cash position from March 1 to June 1.
Here, instead, Export Inc. wants to forecast the change in the value of the cash position from March
Chapter 6, page 27
1 to June 1 given the change in the futures price from March 1 to June 1. Per unit of exposure to the
risk factor, this amounts to finding h so that h times the unexpected change in the futures price from
March 1 to June 1 is the best forecast of the unexpected change in the value of the spot exchange rate
from March 1 to June 1 in the sense that the forecasting error has the smallest volatility. The
volatilityminimizing hedge is then h per unit of exposure to the risk factor. If the change in the
futures price is useless to forecast the change in value of the risk factor, then h is equal to zero and
the futures contract cannot be used to hedge the risk factor. This is equivalent to saying that for the
futures contract to be useful to hedge the risk factor, changes in the futures price have to be
correlated with changes in the risk factor.
We already know how to obtain the best forecast of a random variable given the realization
of another random variable. We faced such a problem in chapter 2. There, we wanted to know how
the return of IBM is related to the return of the stock market. We used the S&P500 as a proxy for
the stock market. We found that the return of IBM can be expected to be IBMs beta times the return
of the market plus a random error due to IBMs idiosyncratic risk. If past returns are distributed like
future returns, IBMs beta is the regression coefficient in a regression of the return of IBM on the
return of the market. To obtain beta using an ordinary least squares regression (OLS), we had to
assume that the return of IBM and the return of the S&P500 were i.i.d. Beta is the forecast of the
exposure of the return of IBM to the return of the market.
If the past changes in the spot exchange rate and the futures price have the same distribution
as the changes over the hedging period, the forecasted exposure and the volatilityminimizing hedge
ratio is the regression coefficient of the change in the spot price on a constant and the change in the
futures price over past periods. Export Inc. can therefore obtain the hedge ratio by estimating a
Chapter 6, page 28
regression. Figure 6.3. shows the regression line obtained using data from Figure 6.2. If we denote
the change in the spot exchange rate corresponding to the ith observation by )S(i) and the change
in the futures price by )G(i), Export Inc. estimates the following regression:
)S(i) = Constant + h*)G(i) + ,(i) (6.1.)
where ,(i) is the regression error or residual associated with the ith observation. A negative value
of the residual means that the change in the exchange rate is lower than the predicted change
conditional on the change in the futures price. Consequently, if we are short the futures contract and
the futures price falls, the gain we make on the futures contract is insufficient to offset the loss we
make on our cash position. Figure 6.3. shows the regression line obtained by Export Inc. using the
100 observations of Figure 6.2. The slope of this regression line gives Export Inc.s estimate of the
exposure to the futures price per SFR and hence its hedge ratio. If the expected changes are different
from zero, this does not matter for the regression coefficient. It would only affect the estimate of the
constant in the regression. The estimate of the constant will be different from zero if the expected
value of the dependent variable is not equal to the coefficient estimate times the expected value of
the independent variable. Consequently, our analysis holds equally well if expected changes are
different from zero, so that the regression would be misspecified without a constant term. From now
on, therefore, we do not restrict expected changes to be zero.
The regression coefficient in a regression of changes in the spot exchange rate on a constant
and on changes in the futures price is our volatilityminimizing hedge for one unit of exposure. The
formula for the volatilityminimizing hedge for one unit of exposure is therefore:
Chapter 6, page 29
h =
Cov( S, G)
Var( G)
=
Hedge ratio
N*Cov( S(i), G(i))
N*Var( G(i))
Cov( S(i), G(i))
Var( G(i))
=
=
We already know that the variance computed over N daily increments is N times the variance over
one daily increment. Consequently, the hedge ratio over N days is:
In that equation, day i could be any day since the covariance and the variance are the same for any
day. It follows from this that the hedge ratio is the same over any hedging period as long as our
assumptions are satisfied. This is a farreaching result, because it tells us that the estimate of the
hedge ratio is not affected by the measurement interval or by the length of the hedging period when
the multivariate normal increment model applies. If our assumptions hold, therefore, how we estimate
the hedge ratio is not dictated by the length of the hedging period. We should not expect to find a
different estimate for the hedge ratio if we use daily or weekly data. Hence, Export Inc. and Trading
Inc. can estimate the hedge ratio using the same regression and use the same hedge ratio despite
hedging over different periods. The precision with which we estimate the hedge ratio increases as we
have more observations, but the regression approach yields an unbiased estimate of the hedge ratio
irrespective of the measurement interval.
Chapter 7: Hedging costs and the portfolio approach to hedging
Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2
Section 7.1. The costs of hedging. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4
Section 7.2. Multiple cash flows occurring at a point in time. . . . . . . . . . . . . . . . . . . . . 16
1. The SFR futures contract helps hedge the yen exposure . . . . . . . . . . . . . . . . 20
2. The yen futures contract helps hedge the SFR and yen exposures . . . . . . . . . 21
Section 7.3. Cash flows accruing at different dates. . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Section 7.4. The i.i.d. returns model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27
Section 7.5. The log increment model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Section 7.5.1. Evaluating risk when the log increments of the cash position are
normally distributed. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33
Section 7.5.2. Var and Riskmetrics . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34
Section 7.5.3. Hedging with i.i.d. log increments for the cash position and the
futures price. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36
Section 7.6. Metallgesellschaft. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40
Section 7.7. Conclusion and summary. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 47
Literature note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49
Review questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50
Questions and exercises . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51
Figure 7.1. Expected cash flow net of CaR cost as a function of hedge. . . . . . . . . . . . . 53
Figure 7.2. Marginal cost and marginal gain from hedging. . . . . . . . . . . . . . . . . . . . . . . 54
Figure 7.3. Optimal hedge ratio as a function of the spot exchange rate and " when the
cost of CaR is "*CaR
2
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Figure 7.4. Short position to hedge Export Inc.s exposure. . . . . . . . . . . . . . . . . . . . . . 56
Figure 7.5. Normal and lognormal density functions. . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Box 7.1. The costs of hedging and Daimlers FX losses. . . . . . . . . . . . . . . . . . . . . . . . . 58
Technical Box 7.2. Derivation of the optimal hedge when CaR is costly . . . . . . . . . . . . 60
Chapter 7: Hedging costs and the portfolio approach to
hedging
December 14, 1999
Ren M. Stulz 1996, 1999
Chapter 7, page 2
Chapter objectives
1. Understand how hedging costs affect hedging policies.
2. Find out how one can reduce hedging costs by taking advantage of diversification.
3. Extend the analysis to the i.i.d. returns model used by Riskmetrics.
4. Examine the Metallgesellschaft case to understand why a widely publicized hedging strategy failed.
Chapter 7, page 3
In the previous chapter, we learned how to hedge a single exposure using forwards and
futures when hedging is costless. In this chapter, we extend the analysis to consider the costs of
hedging and how they affect the hedging decision. When hedging is costly, the firm faces a tradeoff
between the benefit from reducing risk and the cost from doing so. We define the costs of hedging
and explore this tradeoff. Firms almost always have exposures to multiple risk factors. Firm with
exposures to multiple risk factors can reduce hedging costs by treating their exposures as a portfolio.
Typically, some diversification takes place within this portfolio, so that a firm with multiple exposures
puts on a smaller hedge than if it hedges each exposure separately.
To consider portfolios of exposures, we first investigate the case where all exposures have
the same maturity. We show that the approach of the previous chapter can be adapted to construct
a minimumvolatility hedge for the portfolio of exposures. We then turn to the case where a firm has
both multiple cash flows accruing at a point in time and cash flows accruing at different points in time.
In this case, diversification can take place both across exposures at a point in time and across
exposures with different maturities. We show how the firm should measure the risk and hedge
portfolios of exposures with different maturities. One important case where exposures have the same
maturity is a firm with a portfolio of financial securities that manages risk measured by a oneday
VaR. In this case, the firm hedges the change in value over one day, so that exposures effectively
have a oneday maturity. For that case, it generally turns out that it is often more appropriate to
assume that log price increments are identically independently normally distributed in contrast to the
analysis of the previous chapter where price increments were assumed to be identically independently
normally distributed. We therefore consider how our analysis of chapter 6 is affected by making the
assumption of normally distributed log price increments. Finally, we conclude with a detailed study
Chapter 7, page 4
of the Metallgesellschaft case that enables us to understand better the practical difficulties of hedging.
Section 7.1. The costs of hedging.
In chapter 6, we considered two firms, Export Inc. and Trading Inc. Each firm will receive
SFR1M in three months, on June 1. Export Inc. measures risk using CaR and Trading Inc. using VaR.
Each firm views risk to be costly. Consequently, in the absence of costs of hedging, each firm
chooses to minimize risk. In the absence of basis risk, we saw that each firm can eliminate risk
completely. Throughout our analysis, we completely ignored the impact of hedging on the expected
cash flow for Export Inc. or the expected value of the position for Trading Inc. This is correct if
hedging is costless and risk is costly. In this case, the firm just eliminates risk. Though it is possible
for hedging to be costless, there are often costs involved in hedging. Sometimes, these costs are so
small compared to the benefits from hedging that they can be ignored. In other cases, the costs cannot
be ignored. In these cases, the firm trades off the costs and benefits of hedging. We focus only on the
marginal costs associated with a hedge in our analysis. For a firm, there are also costs involved in
having a risk management capability. These costs include salaries, databases, computer systems, and
so on. We take these costs as sunk costs which do not affect the hedging decision.
For the two firms, exposure is known exactly. In a case where exposure is measured exactly,
hedging can alter the expected payoff for two reasons. First, ignoring transaction costs, the hedge can
affect the expected payoff because the price for future delivery is different from the expected spot
price for the date of future delivery. Second, putting on the hedge involves transaction costs. We
discuss these two effects of hedging on the expected payoff in turn. We go through the analysis from
the perspective of Export Inc., but the analysis is the same from the perspective of Trading Inc.
Chapter 7, page 5
From the earlier chapters, we already know that if the exposure has systematic risk, the price
for future delivery differs from the expected cash market price because of the existence of a risk
premium. Suppose that the CAPM accurately captures differences in priced risk across securities. In
this case, if the beta of the SFR is positive, investors who take a long SFR position expect to be
rewarded for the systematic risk they bear. This means that the forward price of the SFR is below the
expected spot price for the maturity date of the forward contract. Since Export Inc. takes on a short
SFR position, it follows that it expects to receive fewer dollars if it hedges than if it does not. Though
hedging decreases the expected payoff in this case, there is no sense in which this reduction in the
expected payoff is a cost of hedging. If the firm does not hedge, it pays the risk premium in the form
of a lower value on its shares. If the firm hedges, it pays the risk premium in the form of a lower
forward price. Either way it pays the risk premium. To avoid treating compensation for risk as a cost,
it is generally best to focus on expected cash flows net of the premium for systematic risk as discussed
in chapter 4.
From the analysis of chapter 2, if one knows the beta of the SFR, one can compute the
markets expected spot exchange rate for the maturity of the forward contract. For instance, if the
beta of the SFR is zero, then the markets expected spot exchange rate is equal to the forward
exchange rate. Lets suppose that this is the case. If Export Inc. has the same expectation for the spot
exchange rate as the market, then there is no cost of hedging except for transaction costs. Suppose,
however, that Export Inc. believes that the expected price for the SFR at maturity of the exposure
is higher than the forward exchange rate. In this case, Export Inc. believes that the forward exchange
rate is too low. With our assumptions, this is not because of a risk premium but because the market
is wrong from Export Inc.s perspective. By hedging, the firm reduces its expected dollar payoff by
Chapter 7, page 6
the exposure times E
(S(June 1))  F, where E(S(June 1)) is Export Inc.s expectation of the price of
the SFR on June 1, S(June 1), as of the time that it considers hedging, which is March 1. This
reduction in expected payoff is a cost of hedging. Hence, when the firm decides to eliminate all risk,
it has to think about whether it is worth it to do so given this cost. Box 7.1. The cost of hedging and
DaimlerBenzs FX losses shows how one company thought through this issue at a point in time.
Besides having different expectations than the market for the cash price, the firm faces costs
of hedging in the form of transaction costs. In the case of Trading Inc., it would have to consider the
fact that the bidask spread is smaller on the spot market than on the forward market. This means that
if there is no systematic risk, the expected spot exchange rate for a sale is higher than the forward
exchange rate for a short position. The difference between these two values represents a transaction
cost due to hedging. We can think of the transaction cost of hedging as captured by a higher forward
price for a firm that wants to buy the foreign currency forward and as a lower forward price for a firm
that wants to sell the foreign currency forward. There may also exist commissions and transaction
taxes in addition to this spread.
When the manager of Export Inc. responsible for the hedging decision evaluates the costs and
benefits of hedging, she has to compare the benefit from hedging, which is the reduction in the cost
of CaR, with the cost of hedging. Suppose the manager assumes that one unit of CaR always costs
$0.5 and that hedging is costly because the forward exchange rate is too low by two cents. The
manager could conclude that the forward exchange rate is lower than the expected spot exchange rate
by 2 cents either because of transaction costs or because the market has it wrong. Remember that
from Table 6.1. the forward exchange rate on March 1 for delivery three months later is $0.6862.
Hence, if the forward exchange rate is too low by 2 cents, the firm expects the spot exchange rate to
Chapter 7, page 7
be $0.7062 on June 1. In this case, going short SFR1M on the forward market saves the costs of
CaR. In chapter 6, CaR for Export Inc. was estimated to be $71,789.20. Consequently, hedging
increases firm value by 0.5*$71,789.20 = $35,894.60. At the same time, however, the manager of
Export Inc. expects to get $20,000 more by not hedging than by using the forward hedge. In this
case, the cost of CaR is so high that Export Inc. hedges even though the forward contract is
mispriced. If the forward contract is mispriced by four cents instead, the firm loses $40,000 in
expected payoff by hedging and gains only $35,894.60 through the elimination of the cost of CaR.
It obviously does not pay for the firm to hedge in this case even though risk reduces firm value.
One can argue whether the firm might have valuable information that leads it to conclude that
the markets expectation is wrong. If markets are efficient, such information is hard to get but this
does not mean that it does not exist or that a firm cannot get it. The problem is that it is too easy to
believe that one has such information. Everybody has incentives to correct mistakes that the market
might have made because this activity makes money. Some individuals and institutions have
tremendous resources at their disposal and spend all their time searching for such mistakes. This
makes it hard to believe that individuals and institutions for whom watching the markets is at best a
parttime activity are likely to have information that is valuable. Having information publicly available,
such as newspaper articles, analyst reports or consensus economic forecasts, cant be worth much.
Since everybody can trade on that information, it gets incorporated in prices quickly. A test of
whether information is valuable at least from the perspective of the manager is whether she is willing
to trade on that information on her own account. If she is not, why should the shareholders take the
risk? Remember that here, the risk involves a cost, namely the impact of the risk on CaR. The bet the
manager wants to take has to be good enough to justify this cost.
Chapter 7, page 8
Lets go back to the case where the forward exchange rate is mispriced by $0.04 when the
cost of CaR is $0.5 per unit of CaR. In this case, it does not pay for Export Inc. to hedge. However,
suppose that Export Inc. not only does not hedge but in addition takes on more foreign exchange risk
by going long SFRs on the forward market to take advantage of the mispricing on the forward
market. Each SFR it purchases on the forward market has an expected profit of $0.04 and increases
the CaR by $0.0717892. Each dollar of CaR costs the firm $0.5. So, the net expected gain from
purchasing a SFR forward is $0.04  0.5*$0.0717892, or $0.0041054. Hence, with this scenario, the
firm can keep increasing its risk by buying SFRs forward with no limits. In this example, therefore,
the firm is almost riskneutral. When a risk has enough of a reward, there is no limit to how much the
firm takes of this risk. One should therefore be cautious about assuming that the cost of CaR is fixed
per unit of CaR. Eventually, the cost of CaR has to increase in such a way that the firm does not take
more risks.
In general, one would therefore expect the cost of CaR per unit to increase as CaR increases.
In this case, there is always an optimal hedge position. The optimal hedge is the one that maximizes
the firms expected cash flow taking into account the cost of CaR. Let Export Inc. go short h SFR
units on the forward market. Suppose further that the cost associated with CaR is " times the square
of CaR, "(CaR)
2
, so that the cost per unit of CaR increases with CaR. In this case, the expected
payoff net of the cost of CaR for Export Inc. is:
Expected cash flow net of the cost of CaR
= Expected cash flow  Cost of CaR per unit of CaR*CaR
= Expected cash flow  "(CaR)
2
Chapter 7, page 9
= (1M  h)E(S(June 1)) + h*F  " [(1M  h)1.65Vol(S(June 1))]
2
Figure 7.1. shows the expected cash flow net of the cost of CaR as a function of h with our
assumptions and shows that it is a concave function. Since the expected cash flow net of the cost of
CaR first increases and then falls as h increases, there is a hedge that maximizes this expected cash
flow. We can obtain this hedge by plotting the expected cash flow net of the cost of CaR and
choosing the hedge that maximizes this expected cash flow. Assuming an expected spot exchange rate
of $0.7102, a forward exchange rate of $0.6902, and a volatility of the spot exchange rate of
0.0435086, we find that the optimal hedge is to go short SFR980,596 if the cost of CaR is $0.0001
per unit, and to go short SFR805,964 if the cost of CaR is $0.00001 per unit. Since hedging has a
positive cost because the forward exchange rate is too low, the firm hedges less as the cost of CaR
falls.
An alternative approach to finding the optimal hedge is to solve for it directly. At the margin,
the cost of hedging has to be equal to the benefit of hedging. Consequently, we can find it by setting
the cost of hedging slightly more (the marginal cost of hedging in the following) equal to the benefit
from doing so (the marginal benefit).
By hedging, one gives up the expected spot exchange rate to receive the forward exchange
rate for each SFR one hedges. Consequently, the expected cost of hedging ) more unit of the cash
position, where ) represents a very slight increase in the size of the hedge, is:
Marginal cost of hedging = )(E(S(June 1))  F)
1
This marginal benefit is obtained by taking the derivative of the cost of CAR with respect
to the size of the hedge.
Chapter 7, page 10
Marginal benefit of hedging for firm with hedge h
= cost of CaR for hedge h  cost of CaR for hedge (h +
M  h)1.65Vol(S(June1))  M  h)  ) *1.65*Vol(S(June1))
= 2 (1M h) 1.65Vol(S(June 1))  1.65Vol(S(June 1))
2 (1M h) CaR per unit of exposure)
2 2
)
(( ((
(
(
=
=
1 1
2 2 2
2
For given ), the marginal cost of hedging does not depend on h. Further, the marginal cost of
hedging depends only on the difference between the spot exchange rate the firm expects and the
forward exchange rate as long as neither transaction costs nor the forward exchange rate depend on
the size of the hedge. Note that in our example, we assume that the spot exchange rate has no
systematic risk. If the spot exchange rate has a positive beta, then we know that the forward exchange
rate is lower than the expected spot exchange rate before transaction costs. In that case, we would
want to consider the marginal cost of hedging after taking into account the risk premium, so that we
would subtract the risk premium from the cash position to compute a riskadjusted cash flow. Once
cash flow is adjusted for risk, hedging has no cost in the absence of transaction costs when the firm
has the same expectation as the market. When the firms expectation of the spot exchange rate differs
from the markets expectation, hedging can have a negative cost if the firm believes that the forward
exchange rate is too high after taking into account transaction costs.
The marginal benefit of hedging is the decrease in the cost of CaR resulting from hedging )
more units of the cash position when ) represents a very slight increase in the size of the hedge:
1
To go to the last line, we use the fact that as long as ) is small enough, the square of ) is so small
Chapter 7, page 11
h M
E(S(June 1))  F
(CaR per unit of exposure)
2
= 1
2
that the second term in the third line can be ignored. Because the cost of risk for the firm is " times
CaR squared, the marginal benefit of hedging turns out to have a simple form. The marginal benefit
of hedging depends on ", the unhedged exposure of SFR1M  h, and the CaR per unit of exposure
squared. The CaR per unit of exposure is fixed. Consequently, the marginal benefit of hedging falls
as the unhedged exposure falls. In other words, the more hedging takes place, the less valuable the
next unit of hedging. Since the firms CaR falls as the firm hedges more, it follows that the lower the
CaR the lower the marginal benefit of hedging. Figure 7.2. shows the marginal cost and the marginal
benefit curves of hedging. The intersection of the two curves gives us the optimal hedge. Increasing
the marginal cost of hedging moves the marginal cost of hedging curve up and therefore reduces the
extent to which the firm hedges. Increasing the cost of CaR for a given hedge h moves the marginal
benefit curve of hedging up and leads to more hedging. We can solve for the optimal hedge by
equating the marginal cost and the marginal benefit of the hedge. When we do so, ) drops out
because it is on both sides of the equation. This gives us:
Suppose that the forward exchange rate is $0.6902, the expected spot exchange rate is 2 cents higher,
" is equal to 0.0001, and the CaR per SFR is $0.0717892. In this case, the optimal hedge applying
our formula is to sell forward SFR998,596. Not surprisingly, the optimal hedge is the same as when
we looked at Figure 7.1. Figure 7.3. shows the optimal hedge for different values of the expected spot
exchange rate at maturity of the exposure and different values of ". In this case, the hedge ratio
becomes one as " increases and the optimal hedge ratio is below one if the forward exchange rate is
Chapter 7, page 12
h Exposure
Expected cash price per unit Price for future delivery per unit
*2*(CaR per unit of exposure)
2
=
(7.1.)
below the expected spot exchange rate and above one otherwise. If the forward exchange rate is
equal to the expected spot exchange rate, the hedge is to go short SFR1M. As the expected spot
exchange rate increases, the hedge falls and can become negative. The hedge falls less if the cost of
CaR is higher because in that case risk is more expensive. As the forward exchange rate increases,
the optimal hedge increases because it is profitable to sell the SFR short when the forward exchange
rate is high relative to the expected spot exchange rate.
The approach we just presented to hedge when CaR is costly gives a very general formula for
the optimal hedge:
Optimal hedge when CaR is costly
The optimal hedge (the size of a short position to hedge a long exposure) when the cost of CaR is
"*CaR
2
and when the cost of hedging does not depend on the size of the hedge is given by the
following expression:
To understand the expression for the optimal hedge, suppose first that the cost of CaR is very large.
In this case, " is very large so that the second term in the expression is trivial. This means that h is
about equal to the total exposure and hence close to the hedge that we would take in the absence of
hedging costs. (Remember from the previous chapter that in the absence of basis risk, the minimum
volatility hedge is to go short the exposure, so that h is equal to the exposure.) As " falls, so that CaR
becomes less expensive, it becomes possible for the firm to trade off the cost and benefit of hedging.
Chapter 7, page 13
n Exposure
E[PV(Spot)] E[PV(F)]
2* *(VaR per unit of unhedged spot)
2
=
The numerator of the second term is the marginal cost of hedging. As this marginal cost increases,
the firm hedges less. The extent to which the firm hedges less depends on the benefit of hedging. As
the benefit from hedging increases, the expression in parentheses becomes closer to zero in absolute
value, so that the firm departs less from the minimumvolatility hedge.
Lets consider how the analysis would be different if we looked at Trading Inc. instead. This
firm uses VaR which is measured over a oneday period. This means that it focuses on the value of
the position tomorrow. So far, when we computed the oneday VaR, we assumed that there was no
expected gain in the position over one day. In this case, it is optimal to reduce VaR to zero if VaR
is costly because there is no offsetting gain from taking on risk. If there is an offsetting gain, then
Trading Inc. trades off the impact of hedging on the expected gain from holding the position
unhedged with the gain from reducing the VaR through hedging. The resulting optimal hedge is one
where the firm equates the cost of hedging one more unit on the expected gain of its position with
the reduction in the cost of VaR from hedging one more unit. Since the difference between the VaR
of Trading Inc. and the CaR of Export Inc. is that the VaR depends on the value tomorrow of
receiving spot exchange rate on June 1 rather than on the spot exchange rate on June 1, the formula
for the optimal hedge when CaR is costly extends to the case when VaR is costly as follows:
where E[PV(Spot)] denotes the expected present value of the SFR unhedged position at the end of
the VaR measurement period (the next day if VaR is computed over the next day) and E[PV(F)]
Chapter 7, page 14
n Exposure
PV(Spot) PV(F)
2*1.65* *(VaR per unit of spot)
1M
0.7296 0.727041
2*0.001*(1.65*0.005262336)
2
2
=
=
=
983 029 ,
denotes the expected present value of the position at the end of the VaR measurement period if it is
hedged. Remember that the SFR position pays SFR1M in three months, so that E[PV(Spot)] is the
expected present value tomorrow of receiving SFR1M in three months. A forward contract that
matures in three months is a perfect hedge for the position, so that PV(F) denotes the present value
tomorrow of the forward exchange rate to be received in three months.
Lets apply our formula to the case of Trading Inc. Suppose that Trading Inc. computes VaR
over one day. From our earlier analysis, we know that each SFR of exposure has a present value of
0.96SFR. Say that we expect the spot SFR to be at $0.76 and the forward SFR to be at $0.75
tomorrow. The PV(Spot) is then 0.96*$0.76 = $0.7296 and PV(Forward) is $0.969388*$0.75 =
$0.727041. The exposure is SFR1M. Vol(PV(Spot)) is the volatility of 0.96 units of spot over one
day, or 0.96*0.0054816 = 0.005262336. We choose " = 0.001. Putting all this in the formula, we
obtain:
Hence, in this case, the firms goes short just about all its exposure because VaR is sufficiently costly
that eliminating the foreign exchange rate risk is the right thing to do. This is not surprising because
with our assumption of " = 0.001, the cost of VaR if the firm does not hedge is large. With our
formula, the cost is $75,392, or 0.001*(1M*1.65*0.00526233)
2
. Suppose that we make the cost of
Chapter 7, page 15
n Exposure
Expected cash value per unit Expected price for future delivery per unit
VaR per unit of exposure)
2
=
2(
(7.2.)
VaR smaller, so that " = 0.0001. The cost of VaR if the firm does not hedge becomes $7,539.2. In
this case, the hedge becomes one where we sell short SFR830,287. Hence, as the cost of VaR falls,
the firm hedges less when hedging has a cost (the cost here is that the firm sells something it thinks
is worth $0.7269 per SFR and gets for it something worth $0.727041 per unit of SFR).
As with the case of Export Inc., we can extend our formula for Trading Inc. to a general
formula for the optimal hedge when the cost of VaR is "(VaR)
2
:
Optimal hedge when VaR is costly
The optimal hedge when the cost of VaR is "VaR
2
is given by the following expression:
This expression has the same interpretation as the expression for the optimal hedge for CaR.
However, now the expected cash value is the one at the end of the VaR horizon and so is the price
for future delivery.
Both formulas for the optimal hedge, equations (7.1.) and (7.2.), have the same important
feature: the optimal hedge is to go short the exposure minus an adjustment factor reflecting the cost
of the hedge. The adjustment factor has the striking property that it does not depend on the exposure
directly. This is because the decision of how much to hedge depends on the marginal benefit and
marginal cost of CaR rather than on the level of the firms CaR. If the adjustment factor is positive,
so that it is costly to hedge, one has to treat the formula with care if the adjustment factor leads to
Chapter 7, page 16
an optimal hedge so extreme that it has the opposite sign from the exposure. For instance, this could
be a case where the firm is long in SFRs and the optimal hedge given by the formula involves buying
SFRs for future delivery. Such a situation could arise for two different reasons. First, suppose that
there are no transaction costs of hedging, but the firm believes that the expected spot price is high
compared to the forward price after adjusting for systematic risk. In this case, going long on the
forward market represents a profit opportunity for the firm if it does not have an exposure and it
should take advantage of it. The exposure means that the firm does not go long as much as it would
without it. Second, suppose that the spot exchange rate expected by the firm is equal to the forward
price before transaction costs, but that the forward price net of transaction costs is low for the short
position because of these costs. In this case, going long forward does not present a profit opportunity
for the firm because the forward price for going long would be different from the forward price for
going short and would be higher than the expected spot price. Hence, if the formula leads to a
negative h with a positive exposure because of transaction costs, this means that the firm should take
no position because going long would create an economic loss. When the expected spot price differs
from the forward price because of transaction costs, therefore, only nonnegative (negative) values
of h should be considered when the exposure is a long (short) position.
Section 7.2. Multiple cash flows occurring at a point in time.
Lets extend the example of the previous chapter to consider the impact on optimal hedges
of multiple exposures. We still consider Export Inc. Now, however, the firm has two exposures that
mature on June 1. One cash flow is the one the firm already has, the cash flow of SFR1M. The other
exposure is a cash flow of 1M. Lets write S
yen
(June 1) for the spot exchange rate of the yen on
Chapter 7, page 17
Variance of unhedged cash flow accruing at time T '
j
i'm
i'1 j
j'm
j'1
Cov[C
i
(T),C
j
(T)]
(7.3.)
June 1 and S
SFR
(June 1) for the spot exchange rate of the SFR at the same time. The variance of the
unhedged cash flow is now:
Variance of unhedged cash flow = Var[1M*S
yen
(June 1) + 1M*S
SFR
(June 1)] =
Var[1M*S
yen
(June 1)] + 2Cov[1M*S
SFR
(June 1),1M*S
yen
(June 1)] + Var[1M*S
SFR
(June 1)]
This formula is similar to the formula we had in chapter 2 for the variance of the return of a portfolio
with two stocks. Not surprisingly, the variance of the total cash flow depends on the covariance
between the cash flows. Consequently, the general formula for the variance of unhedged cash flow
when one has m cash flows accruing at date T is:
where C
i
(T) is the ith cash flow accruing at time T. (Remember that the covariance of a random
variable with itself is its variance.) When a firm has several distinct cash flows accruing at the same
point in time, there is a diversification effect like in portfolios. As in our analysis of portfolio
diversification, the diversification effect is due to the fact that in general the covariance of two
random variables is less than the product of the standard deviations of two random variables because
the coefficient of correlation is less than one. The variance of total unhedged cash flow falls as the
correlation coefficient between the two cash flows falls. If the correlation coefficient between the two
Chapter 7, page 18
cash flows is negative, the firm may have very little aggregate risk. This diversification effect can be
used by the firm to reduce the extent to which it has to hedge through financial instruments to reach
a target CaR.
Lets look at an extreme example. Suppose that the yen and the SFR cash flows have the same
variance but are perfectly negatively correlated. In this case, the aggregate unhedged cash flow of the
firm has no risk, so that no hedging is required. This is because in our formula for the unhedged cash
flow, the two variance terms are equal and the covariance term is equal to the variance term times
minus one. Nevertheless, if the firm looked at the cash flows one at a time, it would conclude that it
has two cash flows that need to be hedged. It would hedge each cash flow separately. If it used
forward contracts for each, it could eliminate all risk. Yet, this is risk that it does not need to
eliminate because in the aggregate it cancels out.
When hedging is costly, the diversification effect can reduce hedging costs by reducing the
number and size of the hedges the firm puts on. To take this diversification effect into account, the
firm should compute optimal hedges from the aggregate cash flow rather than individual cash flows.
Using our example, the aggregate cash flow is:
C
Unhedged
(June 1) = 1M*S
yen
(June 1) + 1M*S
SFR
(June 1)
Suppose that we can use both a SFR futures contract and a yen futures contract that mature on June
1 or later. In this case, the hedged cash flow is:
C
hedged
= C
Unhedged
(June 1)  h
SFR
[G
SFR
(June 1) G
SFR
(March 1)]  h
yen
[G
yen
(June 1)  G
yen
(March 1)]
Chapter 7, page 19
where h
SFR
is the number of units of the SFR futures and h
yen
is the number of units of the yen futures
we short before tailing. The SFR futures contract has price G
SFR
(June 1) on June 1 and the yen futures
contract has price G
yen
(June 1). In the presence of tailing, G
SFR
(June 1)  G
SFR
(March 1) is the gain
from a long position in the SFR futures contracts from March 1 to June 1 equal every day to the
present value of a discount bond the next day that pays SFR1 on June 1. The problem of minimizing
the volatility of hedged cash flow is similar to the one we faced in chapter 6. Since we now have
exposures in two currencies, we want to find a portfolio of positions in futures contracts that evolves
as closely as possible with the value of the cash position. This amounts to finding the portfolio of
futures positions such that changes in the value of these positions best predict changes in the value
of the cash position. We can use a regression to solve our problem.
Lets assume that the exchange rate and futures price increments have the same joint
distribution over time and that they satisfy the multivariate normal increments model presented in
chapter 6. This means that we can use ordinary least squares regression to obtain the volatility
minimizing hedges. We know Export Inc.s exposures, so that we can compute what the value of the
cash position would have been for past values of the exchange rates. Hence, we can regress changes
in the value of the cash position using historical exchange rates on a constant and changes in the
futures prices. The regression coefficients provide us with optimal volatilityminimizing hedges since,
with our assumptions, the distribution of past changes is the same as the distribution of future
changes. The coefficients of the independent variables are the optimal hedges for the dependent
variable. Here, the dependent variable is the change in the value of the cash position. Consequently,
the coefficient for the change in the SFR futures price is the number of SFR units for future delivery
one goes short and the coefficient for the change in the yen futures price is the number of units of yen
Chapter 7, page 20
for future delivery one goes short. The regression we estimate is therefore:
)S
SFR
(t)
*1M + )S
yen
(t)*1M = constant + h
SFR
*)G
SFR
(t) + h
yen
*)G
yen
(t) + ,(t)
where ) denotes a change over a period, so that )S
SFR
(t) is the change in the SFR spot exchange rate
over a period starting at t. The period is the measurement interval for the regression, so that it is a
day if we use daily observations. ,(t) is the random error of our regression. To hedge the cash flow,
Export Inc. should go short h
SFR
(h
yen
) SFR (yen) for future delivery.
Lets try to understand how the number of SFRs for future delivery Export Inc. should go
short differs from the hedge when Export Inc. has only a SFR exposure. The hedge differs because
the SFR futures contract helps hedge the yen exposure and because the yen futures contract helps
hedge the SFR exposure. We discuss these two reasons for why the SFR futures position differs in
this chapter from what it was in the previous chapter in turn:
1. The SFR futures contract helps hedge the yen exposure. To discuss this, lets consider
the situation where Export Inc. hedges using only the SFR futures contract. In this case, treating each
exposure separately, we could estimate a regression of changes in the SFR cash position on changes
in the SFR futures price to get the hedge for the SFR exposure and we could estimate a regression
of changes in the yen cash position on changes in the SFR futures price to obtain the hedge for the
yen exposure. Instead of treating each exposure separately, we can consider them together. In this
case, we estimate a regression where we regress the change in the total cash position on the change
in the SFR futures price. This regression is equivalent to taking the regressions for the SFR and yen
exposures and adding them up. The coefficient of the SFR futures price in this regression is the sum
Chapter 7, page 21
of the coefficients in the regressions for the SFR and yen exposures. The hedge is therefore the sum
of the hedges for the individual exposures. This means that the hedge for the aggregate cash flow
differs from the hedge for the SFR exposure if the regression of the yen on the SFR futures price has
a slope different from zero. This is the case if the SFR futures contract can be used to reduce the risk
of a yen exposure.
The regression coefficient in the regression of the yen position on the SFR futures price has
the same sign as the covariance between changes in the yen spot exchange rate and changes in the
SFR futures price. If the covariance between changes in the yen spot exchange rate and changes in
the SFR futures price is positive, going short the SFR futures contract helps hedge the yen exposure
so that Export Inc. goes short the SFR futures contract to a greater extent than if it had only the SFR
exposure. If the covariance is negative, it has to buy SFRs for future delivery to hedge the yen
exposure. Since it is optimal to sell SFRs for future delivery to hedge the SFR exposure, this means
that Export Inc. sells fewer SFRs for future delivery than it would if it had only a SFR exposure and
hence takes a smaller futures position. In the extreme case where the two exchange rate increments
are perfectly negatively correlated and have the same volatility, the firm takes no futures positions
because the yen exposure already hedges the SFR exposure.
2. The yen futures contract helps hedge the SFR and yen exposures. The SFR futures
contract is likely to be an imperfect hedge for the yen exposure. Suppose, for instance, that the yen
futures contract is a perfect hedge for the yen exposure and that the SFR futures price is positively
correlated with the yen spot exchange rate. In this case, our analysis of the SFR futures hedge of
Export Inc. if it does not use the yen futures contract would lead to the result that it goes short more
than SFR1M for future delivery because the SFR futures contract helps hedge the yen exposure.
Chapter 7, page 22
However, if Export Inc. uses the yen contract also, it will be able to hedge the yen exposure perfectly
with that contract. This means that it will take a smaller short position in the SFR futures contract
than it would if it used only the SFR futures contract. It might even turn out that the yen futures
contract is useful to hedge the SFR exposure in conjunction with the SFR futures contract, in which
case the SFR futures short position would drop even more. The yen futures contract will be helpful
to hedge the SFR exposure if it can be used to reduce the volatility of the hedged SFR exposure when
only the SFR futures contract is used.
From this discussion, it follows that the hedge for the SFR exposure will be the same when
Export Inc. has multiple exposures as when it has only the SFR exposure if (a) the SFR futures
contract does not help to hedge the yen exposure and (b) the volatility of the hedged SFR exposure
when only the SFR futures contract is used cannot be reduced by also using the yen futures contract.
This is the case if the SFR spot exchange rate is uncorrelated with the yen futures price and if the yen
spot exchange rate is uncorrelated with the SFR futures price.
The optimal hedges can be obtained using a similar regression irrespective of the number of
different futures contracts we use to hedge an aggregate cash flow. Hence, if Export Inc. had a cash
flow at date T corresponding to fixed payments in x currencies and we had m futures contracts to
hedge the total cash flow, we could obtain positions in these m futures contracts by regressing the
increment of the total cash flow on the increments of the m futures contracts. Since the total cash
flow is the sum of known payments in foreign currencies, the hedges can be obtained from a
regression using historical data on exchange rates and futures prices assuming that the joint
distribution of futures prices and exchange rates is constant over time. We provide an application of
the use of multivariate regression to compute optimal hedge ratios in section 7.4.
Chapter 7, page 23
Focusing on exposures of aggregate cash flows makes it possible to take advantage of the
diversification effect across cash flows in a way that is not apparent in our discussion so far but is
very important in practice. Consider a firm that has lots of different exposures. It could be that it finds
it difficult to construct good hedges for each of these exposures because the right futures contracts
are not available. In other words, possible hedges would have too much basis risk. It could be,
however, that when the firm considers the aggregate cash flow, there are some good hedges because
the basis risks get diversified in the portfolio. A good analogy is to consider hedging a stock against
market risk. Stock betas are generally estimated imprecisely for individual stocks. Often, they are not
significantly different from zero and the Rsquares of the regressions are low. However, once the
stocks are put in a portfolio, the unsystematic risk gets diversified away, beta is estimated much more
precisely, and the Rsquare is larger. Hence, risk management may be feasible at the level of
aggregate cash flow when it does not seem promising at the level of individual exposures.
Section 7.3. Cash flows accruing at different dates.
The discussion in section 7.2. showed the benefit of using a total cash flow approach to
obtaining the optimal hedge ratios. Applying this approach, it can turn out that a firm needs very little
hedging even though it has large cash flows in a number of different currencies. However, in general,
payments accrue at different dates, thereby creating exposures that have different maturities. Lets
now investigate the case where payments occur at different dates.
If all payments are made at the same date, there is only one cash flow volatility to minimize.
When payments occur at different dates, it is not clear which cash flow volatility we should minimize.
We could try to minimize the cash flow volatility at each date. Doing so ignores the diversification
Chapter 7, page 24
that takes place among payments at different dates. For instance, suppose that a firm must make a
payment of SFR0.9 in 90 days and receives a payment of SFR1M in 100 days. Hedging each cash
flow separately ignores the fact that the payment the firm must make is already to a large extent
hedged by the payment it will receive.
The only way we can take diversification across time into account is if we bring all future
payments to a common date to make them comparable. One solution is to use borrowing and lending
to bring the cash flows to the end of the accounting period and consider the resulting cash flow at that
time. Another solution is to bring all future payments back to the present date. This second solution
amounts to taking present values of future payments we will receive and will have to make. In this
case, we become concerned about the risk of the increments of the present value of the firm over
some period of time. We saw that one measure of such risk is VaR. If all cash flows to the firm are
taken into account in this case and the multivariate normal increments model holds for the cash flows,
VaR is directly proportional to the volatility of firm value increments since firm value is the present
value of future cash flows and since volatility and VaR are proportional to each other with normally
distributed increments. Instead of minimizing the volatility of cash flow at a point in time, volatility
minimization now requires that we minimize the volatility of the increments of the present value of
the firm for the next period of time. With this approach, the optimal hedges change over time because
payments are made, so that the present value of the payments exposed to exchange rate fluctuations
changes over time.
To understand this, lets look at Export Inc. assuming now that it receives a payment of
SFR1M on June 1 and must make a payment of SFR1M on date T. Suppose that Export Inc. wants
to hedge with a futures contract maturing later than date T. The present value of the payments is:
Chapter 7, page 25
Present value of the payments = (P
SFR
(June 1)  P
SFR
(T))*S(March 1)*1M
where P
SFR
(T)) is the price on March 1 of a discount bond paying SFR1 at T. With this equation, the
firm has an exposure of SFR1M*(P
SFR
(June 1)  P
SFR
(T)). Viewed from March 1, the firm has little
exposure if T is close to June 1 since the two discount bonds have similar values. This is because
until June 1 the positive gain from an appreciation of the SFR on the dollar value of the payment to
be received offsets the loss from an appreciation of the SFR on the dollar value of the payment to be
made. One way to understand this limited exposure is to compute the VaR over one day. Suppose
that T is September 1, so that it is six months from March 1, and P
SFR
(March 1, September 1)) = 0.92.
Using the data for the SFR exchange rate, we have:
Oneday VaR = 1.65Vol()S(March 1))[1M*(P
SFR
(March 1, June 1)  P
SFR
(March 1, September 1))]
= 1.65*0.0054816*1M**0.96  0.92*
= $361.8
where *a* denotes the absolute value of a and Vol()S(March 1)) denotes the volatility of the oneday
increment of the SFR spot exchange rate. The oneday VaR is dramatically smaller than if Export Inc.
received only the payment of SFR1M on June 1, which is $8,683, or 1.65*0.0054816*1M*0.96.
Note, however, that if Export Inc. makes the payment a long time in the future, its VaR becomes
closer to what it would be absent that payment. For instance, if the payment were to be made in ten
years and the price of a discount bond maturing in ten years is 0.2, the oneday VaR is $6,874.
To find the hedge that minimizes the volatility of hedged firm value, we need to find a
minimumvolatility hedge ratio for a oneday SFR exposure and then multiply this hedge ratio by our
Chapter 7, page 26
h 1M*(P (May 2, August 1) P (May 2, September 1)) *
Cov( S(t), G(t))
Var( G(t))
SFR SFR
=
exposure. We already know that the volatilityminimizing hedge ratio over one day can be obtained
by regressing the daily change in the SFR on the daily change in the futures price. Letting )S(t) and
)G(t) be respectively the change in the spot exchange rate and the change in the futures price from
date t to the next day, the regression coefficient is Cov()S(t),)G(t))/Var()G(t)). This gives us the
hedge ratio per unit of exposure. The exposure is SFR1M*(P
SFR
(June 1)  P
SFR
(T)). Consequently,
multiplying the exposure with the hedge ratio, we have the optimal hedge h:
Using a regression coefficient of 0.94, a maturity for the payment to be made of September 1, and
P
SFR
(March 1, September 1) = 0.92, the optimal hedge consists in going short SFR37,600 as opposed
to going short SFR902,400 if there was no payment to be made. Over the next day, the two SFR
exposures almost offset each other so that the VaR is small and only a small hedge is required.
Exposures change over time. This was not an important issue when we analyzed Export Inc.s
SFR exposure in the previous chapter because at some point the exposure matured and disappeared.
Here, however, things are dramatically different. As of June 1, the offsetting effect of the two
exposures disappears. Consequently, on June 2, the exposure of Export Inc. is the exposure resulting
from having to make a SFR1M payment at date T. Hence, the exposure increases sharply on June 1,
which makes the hedge change dramatically then also. Before the payment is received on June 1,
Export Inc. goes short SFRs for future delivery by a small amount. After the payment is received, the
only SFR exposure of Export Inc. is the payment it has to make later. As of that time, an unhedged
Export Inc. is therefore short SFRs without any offset from receiving a SFR payment. This means
2
This statement is correct only if the VaR is computed ignoring the expected return,
which is standard practice for computing the oneday VaR.
Chapter 7, page 27
that after June 1, Export Inc. must switch its hedge from being short SFRs for future delivery to being
long SFRs for future delivery. Figure 7.4. shows how the hedge changes over time. The VaR also
evolves over time, in that it is very small until June 1, when it increases dramatically. Since, after the
payment is received on June 1, Export Inc.s exposure is a payment to be made in three months of
SFR1M, the VaR on June 2 is essentially the same as the VaR on March 1 in the previous chapter.
This is because the VaR of a short SFR1M exposure is the same as the VaR of a long SFR1M
exposure.
2
It is important to note that the reasons that a firm finds it advantageous to manage risk are
sometimes such that they preclude it from taking advantage of diversification in cash flows across
time. This is because a firm might be concerned about the cash flow in a given period of time, for
instance a specific year. If that cash flow is low, the firm might not be able to invest as much as it
wants. The fact that there is some chance that a cash flow might later be unexpectedly high is not
relevant in this case. The firm will have to hedge cash flows that accrue before the investment has to
be financed separately to prevent a liquidity crunch.
Section 7.4. The i.i.d. returns model.
So far, we have assumed that the increments of the cash position and of the futures price have
the same joint distribution over time and are serially uncorrelated. In the case of increments to
exchange rates, this made sense. There is little reason, for instance, to believe that the volatility of the
Chapter 7, page 28
exchange rate increments changes systematically with the level of the exchange rate. In the last
section, however, we focused on the increments of present values. In this case, it becomes harder to
assume that these increments have a constant distribution irrespective of the level of the present
values. A simple way to check whether the i.i.d. increments model is appropriate is to perform the
following experiment. Since, with the i.i.d. increments model, the distribution of increments is always
the same, we can put increments in two bins: those increments that take place when the price or
present value is above the sample median and the other increments. The mean and volatility of
increments in the two bins should be the same if the i.i.d. increments model holds.
To understand the issue, think about a common stock, say IBM. The statistical model we have
used so far would state that the distribution of the dollar increment of a share of IBM is the same
irrespective of the price of a share. This implies that if the price of an IBM share doubles, the
expected return of the share falls in half. Why so? Suppose that we start with a price of $50 and say
an expected increment of $1 over a month. This corresponds to a monthly expected return of 2%
(1/50 times 100). Suppose now that the price doubles to become 100. In this case, the assumption
of i.i.d. increments implies that the expected increment is also $1. Consequently, the expected return
on the share becomes 1% (1/100 times 100). With i.i.d. increments, therefore, the expected return
on a share falls as its price increases! We know that this cannot be the case if the CAPM holds since
with the CAPM the expected return depends on beta rather than on the stock price. Another
implication of i.i.d. dollar increments is that the standard deviation of the increments becomes a
smaller fraction of the price as the price increases. One way to put that is that increments of prices
that have increased a lot experience a fall in volatility.
With stock prices, a more sensible approach is to assume that the returns are i.i.d. To see the
Chapter 7, page 29
implications of this assumption, suppose that you want to hedge IBM with a position in the market
portfolio. The beta of IBM is the regression coefficient of a regression of the return of IBM on the
return of the market portfolio. Using the logic of our hedging analysis, this regression coefficient
gives us the best forecast of the return of IBM for a given return on the market portfolio. A return
is a dollar increment on one dollar. Hence, if the beta of IBM is 1.1, for each $1 gain on the market
portfolio, a dollar invested in IBM earns $1.1. This means that to hedge IBM we go short $1.1. on
the market. Suppose that we have $1M invested in IBM. Then, we go short $1.1M in the market. If
the market falls by 10%, we expect our IBM investment to fall by 11%. Consequently, we expect to
lose $110,000 on our IBM investment and gain $0.10*1.1M, or $110,000 on our short position in
the market.
After the market fell by 10%, our investment in IBM is worth $890,000 if IBM fell by the
amount predicted by our regression, namely a return equal to IBMs beta times the market return.
Lets assume that this is the case. To hedge this, we need to go short 1.1*$890,000 in the market.
If the joint distribution of returns is i.i.d., the joint distribution of dollar increments is not. The hedge
therefore has to change as the value of the position changes. To see how important it is to change the
hedge, suppose we forget to change it. We therefore have a short position in the market of $1.1M.
This position is too large compared to the short position we should have of 1.1*$890,000, or
$979,000. Suppose now the market increases by 10% and IBM increases by 11% as predicted by the
regression equation. In this case, we gain 0.11*$890,000 on IBM, or $97,900, and we lose
0.10*$1.1M, or $110,000, on our short position on the market. On net, therefore, if we forget to
change the hedge, we lose $12,100 as the market increases by 10%. If we had adjusted the hedge,
we would have lost 0.10*$979,000 on our short position on the market and this loss would have
Chapter 7, page 30
offset the gain on IBM.
When the distribution of the returns is i.i.d. instead of the distribution of the dollar increments,
the regression of the dollar increments of the cash position on the dollar increments of the hedging
instrument is misspecified. Remember that the regression coefficient in such a regression is the
covariance of the dollar increments of the cash position with the dollar increments of the hedging
instrument divided by the variance of the dollar increments of the hedging instrument. If returns are
i.i.d., the covariance term in the regression coefficient depends on the value of the cash position and
on the price of the hedging instrument. Therefore, it not constant. The regression of the returns of
the cash position on the returns of the hedging instrument is wellspecified because, if returns are
i.i.d., the covariance between the returns of the cash position and the returns of the hedging
instrument is constant. The regression of the returns of the cash position on the returns of the hedging
instrument gives us the optimal hedge ratio for a dollar of exposure. In the case of IBM, the
regression coefficient is 1.1. which means that we need to be short the market for $1.1 for each $1
we are long in IBM. Multiplying the regression coefficient by the dollar exposure gives us the dollar
short position we need. If the hedging instrument is a futures contract, we have no investment and
hence there is no return on the futures contract. However, we can still apply our reasoning in that we
can use as the return in our regression analysis the change in the futures price divided by the futures
price.
Our discussion so far in this section gives us a general result for the hedge ratio when returns
are jointly i.i.d.:
Volatilityminimizing hedge when returns are i.i.d.
Chapter 7, page 31
Volatility minimizing hedge of cash position
Cov[r(cash), r(hedge)]
Var[r(hedge)]
Cash position = *
(7.4.)
Consider a cash position worth C dollars. The return on the cash position is r(cash). The return on
the hedging instrument is r(hedge). With this notation, the volatilityminimizing hedge is given by:
Equation (7.4.) makes clear that the optimal hedge in this case depends on the size of the cash
position. As the cash position increases, the optimal hedge involves a larger dollar amount short in
the hedge instrument.
With our IBM example, the regression coefficient of IBMs return on the markets return is
1.1. With a cash position of $1M, using equation (7.4.) tells us that we have to go short the market
$1M times 1.1., or $1.1M.
Section 7.5. The log increment model.
An issue that we have not addressed so far is the measurement interval for returns. One choice
that has substantial advantages over others is to use continuously compounded returns. Consider a
stock price P(t) at t. The price becomes P(t+)t) after an interval of time )t has elapsed. The
continuously compounded return over )t is the log price increment: log(P(t+)t))  log(P(t)). We
have used the assumption that the dollar increment is i.i.d. and normally distributed. The dollar
increment is P(t+)t)  P(t). If we assume that the log price increment is i.i.d. and normally distributed
instead, the sum of log price increments is normally distributed. Since the log price increment is the
continuously compounded return over the period over which the increment is computed, this means
that continuously compounded returns are i.i.d. and normally distributed. We assume that the log
Chapter 7, page 32
price increments are i.i.d. and normally distributed as the period over which the increment is
computed becomes infinitesimally small. As a result, log price increments are normally distributed
over any measurement period.
A random variable is said to have a lognormal distribution if its logarithm has a normal
distribution: X follows a lognormal distribution when X = Exp(y) and y follows a normal distribution
since log(X) = y, so that the log of the random variable X is normally distributed. If y = log (P(t+)t))
 log(P(t)), we have that Exp(log(P(t+)t))log(P(t))) =P(t+)t)/P(t). Consequently, P(t +)t)/P(t) is
lognormally distributed. Since Exp(minus infinity) is the lowest value a lognormally distributed
random variable can take, the price cannot have a negative value. This makes the lognormal
distribution attractive for stock prices since it precludes negative stock prices. Figure 7.5. shows the
density function of a normally distributed random variable and of a lognormally distributed random
variable. If we assume that returns are normally distributed when measured over a different time
period, it is possible for the stock price to be negative because with the normal distribution, returns
can take very large negative values.
If log increments are normally distributed over some period of time, say )t, they are normally
distributed over any measurement interval. Consider the log increment over a period of k*)t. This
is the sum of log increments computed over k periods of length )t. However, a sum of normally
distributed random variables is itself normally distributed. Consequently, if the log increment is i.i.d.
and normally distributed over a period of length )t, we can obtain its distribution over intervals of
any other length from its distribution over the interval of length )t.
If the simple return over an interval of )t is i.i.d. and normally distributed, it is not the case
that the simple return over an interval of k*)t is i.i.d. and normally distributed. The reason for this
Chapter 7, page 33
is that compounding is involved in getting the simple return over the longer interval. If r is the simple
return over one interval, the simple return over k intervals is (1+r)
k
. This compounding implies that
the simple return over multiple intervals involves products of the simple returns. If a simple return
is normally distributed, the simple return of a longer interval consists of products of simple returns
that are normally distributed. Products of normally distributed random variables are not normally
distributed. This means that if weekly simple returns are normally distributed, monthly simple returns
cannot be. In contrast, if continuously compounded returns measured over a week are normally
distributed, then continuously compounded returns measured over a month are normally distributed
also.
Section 7.5.1. Evaluating risk when the log increments of the cash position are normally
distributed.
Lets now look at the case where the continuously compounded return of a position is
normally distributed. Since we know the distribution of the continuously compounded return, the
VaR over one day ignoring the expected return is simply 1.65 times the volatility of the continuously
compounded return over one day times the value of the position. The formula for the VaR of an asset
with value S(t) and normally distributed continuouslycompounded returns is therefore:
Formula for VaR when continuously compounded returns are normally distributed
The formula for the VaR for a position with value at t of S(t) is:
VaR = S(t)*1.65*Vol[Continuously compounded return over one day]
Chapter 7, page 34
Suppose that you have an asset worth $50M and that the continuously compounded return has a one
day volatility of 1%. In this case, the VaR is $50M*1.65*0.01, or $825,000.
Consider the following example. You have a portfolio of $100 million invested in the world
market portfolio of the Datastream Global Index on September 1, 1999. You would like to know the
VaR of your portfolio at a onemonth horizon assuming the continuously compounded returns are
normally distributed. The volatility of the monthly log return of the world market portfolio from
January 1, 1991 to September 1, 1999 is 0.0364 in decimal form. Multiplying the volatility by 1.65,
we have 0.0606. The expected log increment is 0.0093. Subtracting 0.0606 from 0.0093, we obtain
0.05076. The VaR of our portfolio is therefore $5.076M. This means that one month out of twenty
we can expect to lose at least $5.076M.
It is straightforward to see why assuming that the increments to the world market portfolio
are normally distributed would be nonsensical. The world market portfolio was worth $6,818B on
January 1, 1991. By September 1, 1999, its value had almost quadrupled to $26,631B. If dollar
increments are normally distributed, this means that the expected dollar increment is the same in
January 1991 and in September 1999. This would mean that in September 1999, the expected rate
return of the world market portfolio and the standard deviation of return are about 1/4th of what they
were in 1991!
Section 7.5.2. Var and Riskmetrics.
The procedure we just discussed to compute the risk measure is widely used. It is the
foundation of the approach to computing VaR proposed by Riskmetrics. With that approach, daily
Chapter 7, page 35
log increments are assumed to be normally distributed and the mean of daily log increments is
assumed to be zero. However, distributions of increments change over time and these changes have
to be accommodated. For instance, in 1987, after the October Crash, the volatility of the stock
market increased dramatically for a period of time. If the distribution changes over time, at date t, we
are estimating the distribution of the next log increment based on the information available to us up
to that point. This distribution is the conditional distribution. For instance, we would choose a
different distribution of increments for tomorrow if we knew that volatility has been high over the last
week than if we knew that it has been low. Consequently, Riskmetrics does not assume that the
distribution of continuously compounded returns is i.i.d. It only assumes that the distribution of
increments looking forward from a point in time, the conditional distribution, is the normal
distribution.
The procedure used by Riskmetrics to obtain estimates of variances and correlations puts
more weight on recent observations. Consequently, this procedure effectively presumes that variances
and correlations are not constant over time. It uses no other data than the timeseries of observations,
however. One could think of models to estimate variances and correlations that use other information.
For instance, one might forecast the markets volatility using a model where the markets volatility
depends on the level of interest rates or on the volume of trades. This is a topic of active research
among financial economists. A simple way to cope with the fact that variances and correlations might
change over time is to use recent data only to estimate variances and correlations. It is also a good
idea to examine the data for changes in distributions. If in a timeseries plot of the data, one sees a
period that is quite different from the current period, it may make sense to start the sample after that
period if one believes that the period is somehow unique.
Chapter 7, page 36
Riskmetrics makes its estimates of the volatilities and correlations freely available over the
internet. It computes these volatilities and correlations for a large and growing number of assets  in
excess of 400. A large institution will have thousands of different assets. Consequently, to simplify
the problem of computing its VaR, it will choose to assign assets into bins. Assets that are similar will
be put into these bins. One way of creating the bins is to use the Riskmetrics assets. We will
consider this problem for fixed income portfolios in chapter 9.
Section 7.5.3. Hedging with i.i.d. log increments for the cash position and the futures price.
We already saw that when returns are i.i.d., the regression approach gives us an optimal hedge
for a cash position of one dollar. Nothing is changed in that analysis if continuously compounded
returns are i.i.d. Using log increments in the regression analysis gives us the optimal hedge per dollar
of cash position. The one question that arises is whether using log increments instead of simple
returns makes an important difference in the computation of the optimal hedge. The answer is that
generally it does not.
Consider the following problem. As in the VaR example, we have a position of $100M dollars
in the world market portfolio on September 1, 1999. We believe that there is a higher probability that
the world market portfolio will have a negative return during the next month than the market believes.
We therefore want to hedge the position for the coming month using futures. After the end of the
month, we will reconsider whether we want to hedge. The reason we hedge rather than sell is that
it is much cheaper to hedge with futures than to incur the transaction costs of selling the shares. As
we saw, it makes sense to assume that the log increments of the world market portfolio are i.i.d. By
the same token, we can assume that the log increments of index futures are also i.i.d. Lets consider
Chapter 7, page 37
the case where we use two futures contracts to hedge: the S&P 500 contract and the Nikkei contract.
The Nikkei contract traded on the IMM gives payoffs in dollars.
Regressing the monthly log increments of the world market portfolio on a constant and the
log increments of the futures contracts from January 1, 1991 to September 1, 1999 gives us:
)Log(World index) = c + $ $)Log(S&P 500) + ( ()Log(Nikkei) + ,
0.0048 0.6905 0.2161
(0.26) (12.91) (7.72)
We provide the tstatistics below the coefficients. These coefficients show that the log increments of
the world index are positively related to the log increments of the S&P500 and of the Nikkei. The
exposure of the world market to the S&P 500 is greater than its exposure to the Nikkei. Both
exposure coefficients are estimated precisely. The standard error of the estimate of the S&P 500
futures coefficient is 0.054 and the standard error of the estimate of the ( coefficient is 0.028. The
regression explains a substantial fraction of the variation of the log increments of the world market
portfolio since the R
2
is 0.7845. This R
2
means that we can expect to hedge 78.45% of the variance
of the world market portfolio with the two futures contracts.
Consider now the implementation of this hedge where the hedge is adjusted every month.
Effectively, we hedge over a month, so that tailing is trivial and can be ignored. The Nikkei contract
is for $5 times the Nikkei. Consequently, the contract is for a position in the Nikkei worth $89,012,4
on September 1, 1995, since on that day the Nikkei stands at 17,802.48. The S&P contract is for 500
times the S&P 500. The S&P 500 is at 1,331.06 on September 1, 1999, so that the contract
Chapter 7, page 38
corresponds to an investment of 1,331.06*500 in the S&P 500, namely $665,531.5. The regression
coefficient for the S&P 500 is 0.69048. This means that one would like a position in the S&P 500
futures of $69,048,000 (i.e., 0.69048*$100M). A one percent increase in that position is $690,480.
The expected increase in the value of the portfolio if the S&P500 increases by one percent is
0.69048*$100m = $690,480 as well. To obtain the number of S&P 500 futures contracts, we divide
69,048,000 by 665,531.5. The result is 103.7, which we round out to 104 contracts. To get the
number of Nikkei contracts, we would like a Nikkei position worth $21,609,000. The best we can
do is 243 contracts since 21,609,000/89,012.4 = 242.8. On October 1, the hedged portfolio is worth:
Initial cash portfolio $100,000,000
Gain on cash portfolio $1,132,026
($100M*(1059.4  1071.53)/1071.53)
Gain on S&P500 futures $2,509,000
104*500*(1281.81 1331.06)
Gain on Nikkei position $109,253
243*5*(17,712,56  17,802.48)
New portfolio value $101.486,227
Note that, in this case, in the absence of hedging we would have lost more than $1M. Because of the
hedge, we end up earning more than $1M. One might argue that this shows how valuable hedging
is since we can earn more than $1M instead of losing more than $1M. However, while hedging helps
us avoid a loss, the fact that we earn that much on the hedged portfolio is actually evidence of an
Chapter 7, page 39
imperfect hedge. Remember that if we hedge a portfolio of stocks completely, the hedged portfolio
is a riskfree asset that earns the riskfree rate. On September 1, 1999, the riskfree rate would have
been less than 0.5% a month, so that the riskfree return on our hedged portfolio would have been
less than $500,000. We therefore earned on the hedged portfolio close to a million dollars that we
would not have earned had the hedged portfolio been riskfree. This is because the world market
portfolio includes markets that have little correlation with the U.S. and Japanese markets. We could
therefore try to use additional futures contracts to hedge the world market portfolio. For instance,
there is a futures contract traded on the U.K. market which could help us hedge against European
market risks that are not correlated with the U.S. and Japanese market risks. Since this contract is
traded in pounds, the hedging portfolio would become more complicated.
Consider now the futures positions on October 1, 1999. If we change them monthly, then we
have to reexamine these positions at that time. Our portfolio now has $101,486,227 invested in the
world market portfolio assuming that we reinvest all the futures gains in the world market portfolio.
To hedge, assuming that the regression coefficients are still valid, we need a position in the S&P 500
of 0.69048*$101,486,227 = $70,074,210. At that date, the S&P 500 is at 1,282.81, so that the
number of contracts we would like is 70,074,210/(1,282.81*500) = 109. Hence, our S&P 500
position increases by 5 contracts. What about our Nikkei position? We need to compute
0.21609*101,486,227/(5*17,712.56). This gives us 248 contracts. We therefore want to go short 248
contracts, which is five more contracts than we had initially.
In this example, we readjust the hedge every month. If the cash position and the futures prices
are highly volatile, one will generally be better off readjusting the hedge more often. In this case,
however, not much happens during the hedging period. The best recommendation is therefore to
Chapter 7, page 40
adjust the hedge when significant changes occur.
Section 7.6. Metallgesellschaft.
A useful way to put all the knowledge we have acquired about hedging together is to consider
the experience of a firm with futures hedging and evaluate that experience. Metallgesellschaft AG is
a German firm that hedged with futures and, despite its hedges, faced important difficulties. It offers
a perfect case study to evaluate the problems that can arise with futures hedges and the mistakes that
can be made in hedging programs that use futures. In December 1993, Metallgesellschaft AG
headquartered in Frankfurt, Germany, faced a crisis. It had made losses in excess of one billion dollars
on futures contracts. The chief executive of Metallgesellschaft AG was fired, a package of loans and
debt restructuring was put together, and eventually large amounts of assets were sold. The losses
brought about a drastic reorganization of the firm. The losses of Metallgesellschaft are among the
highest reported by firms in conjunction with the use of derivatives. Are derivatives to blame? The
board of directors of the firm thought so and changed the firms strategy after becoming aware of the
losses. Others, especially Merton Miller of the University of Chicago, have accused the board of
directors of panicking when it had no reason to do so and of giving up a sound business strategy.
Even though the case of Metallgesellshaft has generated strong controversies, there is general
agreement about the facts of the case. Metallgesellschaft is a large German company with interests
in metal, mining, and engineering businesses. In 1993, it had sales in excess of $16B dollars and assets
of about $10B dollars. It had 15 major subsidiaries. MG Corp was the U.S. subsidiary of
Metallgesellschaft. Its equity capital was $50M dollars. It was mostly a trading operation, but it had
an oil business organized in a subsidiary called MG Refining and Marketing (MGRM). MGRM had
Chapter 7, page 41
a 49% stake in a refiner, Castle Energy. It had contracted to buy from this company its output of
refined products, amounting to approximately 46M barrels per year at guaranteed margins for up to
ten years. MGRM then turned around and offered longterm contracts in refined products at fixed
prices. With this business strategy, MGRM provided insurance to retailers by selling them oil at fixed
prices. It thought that its expertise would enable it to make this strategy profitable.
The fixedprice contracts offered by MGRM consisted of three types. The first type of
contract required the buyer to take delivery of a fixed amount of product per month. This type of
contract, most of them with a maturity of ten years, accounted for 102M barrels of future deliveries.
The second type of contract had fixed prices but gave considerable latitude to buyers concerning
when they would take delivery. This type of contract, again mostly running ten years, accounted for
52M barrels of future deliveries. Finally, there was a third type of contract, which had flexible prices.
Essentially, at the end of 1993, MGRM had therefore guaranteed delivery at fixed prices of 154M
barrels of oil.
To alleviate credit risk, MGRM allowed buyers to take fixed price contracts for a fraction of
their purchases of oil not exceeding 20%. It further included cashout options. With the first type of
contracts, buyers could cash out and receive half the difference between the nearterm futures price
and the fixed price times the remaining deliveries. With the second type of contracts, they would
receive the full difference between the second nearest futures contract price and the fixed price times
the amount not yet delivered.
With these contracts, MGRM took on a large exposure to fluctuations in oil prices. Since it
would pay spot prices to Castle and would receive fixed prices from retail customers, increases in oil
prices could potentially bankrupt the company. MGRM therefore decided to hedge. However, it did
Chapter 7, page 42
not do so in a straightforward way. Remember that the fixedprice contracts have a maturity of 10
years, so that MGRM would keep paying spot prices to Castle over the next ten years. To analyze
the issues involved in MGRMs hedging, lets assume for simplicity that the fixed price contracts have
no credit risk, no flexible delivery dates, and no cashout options. In this case, the simplest way for
MGRM to eliminate all risks would be to buy a strip of forward contracts where each forward
contract has the maturity of a delivery date and is for a quantity of oil corresponding to the quantity
that has to be delivered on that date. If MGRM had done this, it would have been perfectly hedged.
It would no longer have had an exposure to oil prices.
MGRM chose not to buy a strip of forward contracts. It did so for two reasons. First, buying
a strip of forward contracts would have been expensive because it would have required using over
thecounter markets of limited liquidity. This issue made a strategy using shortterm futures contracts
more attractive. Mello and Parsons (1995) argue that the minimumvolatility hedge would have
involved buying 86M barrels in the short maturity futures contract. Pirrong (1997) estimates the
minimumvolatility hedge differently and under most of his assumptions the minimumvolatility hedge
is lower than the one obtained by Mello and Parson. One can argue about some of the assumptions
of these studies, but it is certainly the case the minimum volatility hedge involved a long position in
the short maturity futures contract of much less than 154M barrels. This is the case for two important
reasons. In chapter 6, we talked about the necessity to tail the hedge and pointed out that tailing can
have a dramatic impact in a situation where we are hedging exposures that mature a number of years
in the future. Here, Metallgesellschaft is hedging some exposures that mature in 10 years. When
hedging these exposures, the tailing factor should therefore be the present value of a discount bond
that matures in ten years. This reduces sharply the size of the hedge. In addition, remember from our
Chapter 7, page 43
analysis that basis risk decreases the size of the hedge relative to the cash position. In this case, rolling
over shortterm contracts exposes MGRM to substantial rollover risk that should decrease its
position. Despite these considerations, MGRM bought 154M barrels in short maturity contracts.
Some of these contracts were futures contracts, but others were traded over the counter. Hence, in
no sense did MGRM use a minimumvolatility hedge.
This brings us to the second reason why they did not buy a strip of forward contracts. For any
maturity, a forward price is the spot price plus a forward premium. The minimum volatility hedge of
86M barrels is computed ignoring expected returns altogether. In contrast, MGRM thought that,
whereas it did not have good information about future spot prices, it had good information on basis.
Its view was that the typical relation was one of backwardation, meaning that prices for future
delivery are lower than spot prices, and that such a relation implies that a long futures position would
have a positive expected return as futures prices converge to spot prices at maturity. With such a
view, even if MGRM was not exposed to oil prices, it would want to take a long position. The
magnitude of this speculative position in futures would depend on the willingness to bear risk and on
the magnitude of the expected profit. Since MGRM had an exposure to the price of oil, the positive
expected return on futures increased its long position relative to the optimal hedge. MGRM ended
up having a long position of 154M barrels of oil. The argument that makes sense of such a position
is that with this position MGRM was exposed to the basis but not to oil prices  eventually, it would
take delivery on every one of the contracts as it rolled them over.
From the perspective of the optimal hedging theory developed so far, the long position of
154M barrels can be decomposed in a pure hedge position of 86 million barrels of oil and a
speculative position of 68M barrels of oil. MGRM was net long in oil prices. As prices fell
Chapter 7, page 44
dramatically in 1993, it lost on its futures positions. Each dollar fall in the price of oil required margin
payments of $154M. Whereas the losses on the minimumvolatility position were exactly offset by
gains on the fixedprice contracts, the losses on the speculative positions had no offset and were
losses in the market value of Metallgesellschaft. In other words, assuming that the computation of
the minimumvolatility hedge is correct, the margin payment of $154M for a dollar fall in the price
of oil was offset by an increase in the value of the longterm contracts of $86M. The net loss for
Metallgesellschaft of a one dollar fall in the price of oil was $68M.
MGRMs speculative position was based on gains from backwardation. Adding to the losses
of MGRM was the fact that in 1993 the markets were in contango. This means that futures prices
were above spot prices. Hence, the source of gains on which MGRM had counted on turned out to
be illusory that year. Instead of making rollover gains from closing contracts at a higher price than
the contracts being opened (i.e., with backwardation, the maturing contract is close to the spot price
which is above the futures price of the newly opened contract with a longer maturity),
Metallgesellschaft made rollover losses. These rollover losses were of the order of $50M every
month.
The massive losses on futures contracts grew to more than one billion dollars. Some of these
losses were offset by gains on the fixed price contracts, but the net loss to the corporation was large
because of the speculative position. The losses on futures contracts were cash drains on the
corporation since the gains on the fixed price contracts would only be recovered later. A hedging
program that generates a cash drain at its peak of about one billion dollars on a corporation with
assets of ten billion dollars can only create serious problems for that corporation. At the same time,
however, Metallgesellschaft could have raised funds to offset this liquidity loss. If Metallgesellschaft
Chapter 7, page 45
thought that the speculative position was sound at the inception of the program, it should have still
thought so after the losses and hence should have kept taking that position since doing so would have
maximized shareholder wealth. However, losses lead people to look at their positions more critically.
Hence, it might not have been unreasonable to expect a change in policy. In particular, it was harder
to believe that backwardation was a free lunch.
Was the MGRM debacle a hedge that failed or was Metallgesellschaft a gutless speculator?
After all, if it really believed that backwardation made money, the losses of 1993 were irrelevant. The
strategy had to be profitable in the long run, not necessarily on a month by month or year by year
basis. Losses could lead Metallgesellschaft to give up on the strategy only if it changed its position
as to the expected profits of the speculation or could not afford the liquidity costs of the speculation.
Since Metallgesellschaft had lines of credit that it did not use, the most likely explanation is that the
company gave up on the strategy. As it changed direction, the board wanted the new management
to start on a clean slate and so decided to take all its losses quickly. This practice of taking a bath
around management changes is not unusual, as discussed in Weisbach (1995).
What do we learn from the Metallgesellschaft experience? Mostly that large losing futures
positions create liquidity drains due to the requirement to maintain margins and that it pays to
compute correct minimumvolatility hedges. When implementing a hedging program with futures
contracts, it is therefore crucial to plan ahead for meeting the liquidity needs resulting from losing
futures positions. The VaR of the futures contract provides an effective way to understand the
distribution of the liquidity needs. With VaR, we know that over the period for which the VaR is
computed, we have a 5% chance of losing that amount. A hedge that develops losing futures
positions is not a bad hedge. On the contrary, if the hedge is properly designed, losing futures
Chapter 7, page 46
positions accompany winning cash positions, so that on net the company receives or loses nothing
when one uses present values. However, the gains and losses of the companys positions might have
different implications for the companys liquidity. With Metallgesellschaft, the gains from a fall in oil
prices would have to be paid over time by the holders of longterm contracts whereas the losses from
futures prices had to be paid immediately.
Even though a hedged position may have no economic risk, it can be risky from an accounting
perspective. This issue played a role in the case of Metallgesellschaft. In principle, a hedge can be
treated from an accounting perspective in two conceptually different ways. First, the cash position
and the hedge can be treated as one item. In this case, the losses on the hedge are offset by gains in
the cash position, so that losses on a hedge position that is a perfect hedge have no implications for
the earnings of the firm. Alternatively, the hedge position and the cash position can be treated
separately. If accounting rules prevent the gains in the cash position that offset the losses in the hedge
position from being recognized simultaneously, a firm can make large accounting earnings losses but
no economic losses on a hedged position.
An intriguing question with the Metallgesellschaft case is whether the firm would have done
better had it not hedged than with the hedge it used. From a risk management, the only way this
question makes sense is to ask whether Metallgesellschaft had more risk with the wrong hedge than
with no hedge at all. The answer to that question depends on the assumptions one makes. A least one
study, the one by Pirrong (1997) reaches the conclusion that an unhedged Metallgesellschaft would
have been less risky than the Metallgesellschaft with the hedge it used. Irrespective of how this
question is decided, however, the risk of Metallgesellschaft would have been substantially smaller had
it used the appropriate volatilityminimizing hedge. However, if one believes that backwardation is
Chapter 7, page 47
a source of profits, Metallgesellschaft with the volatilityminimizing hedge would have been less
profitable ex ante.
Section 7.7. Conclusion and summary.
Hedging can be expensive, but it need not be so. When one hedges with derivatives traded
in highly liquid markets, hedging generally has a low cost. Nevertheless, it is important to be able to
deal with situations where the costs of hedging are high. To do so, one has to have a clear
understanding of the costs of the risks that one is trying to hedge. We saw how this understanding
can be put in quantitative terms to derive an optimal hedge. We showed that firms with lower costs
of hedging or greater costs of risks hedge more. We then showed that treating exposures as portfolios
of exposures reduces the costs of hedging because doing so takes into account the diversification
across risks. In general, when a firm has exposures maturing at different dates, one has to focus on
their present value or their value at a terminal date. When one considers the present value of
exposures, one effectively uses VaR. We saw that with VaR it often makes more sense to think that
the return of a position is i.i.d. rather than the dollar increment. We therefore developed the hedging
model for positions that have i.i.d. returns. We concluded the chapter with a detailed discussion of
the difficulties faced by Metallgesellschaft in its hedging program.
Chapter 7, page 48
Literature note
Portfolio approaches to hedging take into account the expected gain associated with futures
contracts as well as the risk reduction resulting from hedging. A number of papers discuss such
approaches, including Rutledge (1972), Peck (1975), Anderson and Danthine (1981, 1983), Makin
(1978) and Benninga, Eldo, and Zilcha (1984). Stulz (1983) develops optimal hedges in the presence
of transaction costs. The analysis of this chapter which uses CaR and Var is new, but given our
assumptions it is directly related to the analysis of Stulz (1983). Witt, Schroeder, and Hayenga (1987)
compare different regression approaches to obtaining hedge ratios. Bailey, Ng, and Stulz (1992) study
how hedges depend on the estimation period when hedging an investment in the Nikkei 225 against
exchange rate risk. The Riskmetrics technical manual provides the details for their approach and
is freely available on the internet. Extending optimal hedging models to take into account the liquidity
of the hedging firms turns out to be difficult as demonstrated by Mello and Parsons (1997). However,
their work shows that firms with limited liquidity may not be able to hedge as much and that careful
attention has to be paid to liquidity.
Culp and Miller (1994) present the view that the hedging strategy of Metallgesellschaft was
sensible. Edwards and Canter (1995), Mello and Parsons (1995) and Pirrong (1997) provide estimates
of the minimumvolatility hedge for Metallgesellschaft.
Chapter 7, page 49
Key concepts
Hedging costs, cost of CaR, lognormal distribution, i.i.d. returns model, log increment model.
Chapter 7, page 50
Review questions
1. Why could hedging be costly?
2. Why hedge at all if hedging is costly?
3. What is the marginal cost of CaR?
4. What is the optimal hedge if hedging is costly?
5. Why does diversification across exposures reduce hedging costs?
6. How does diversification across exposure maturities reduce hedging costs?
7. When is the i.i.d. increments model inappropriate for financial assets?
8. What is a better model than the i.i.d. increments model for financial assets?
9. How can we find the optimal hedge if returns are i.i.d.?
10. How does the optimal hedge change through time if returns are i.i.d.?
10. What model for returns does Riskmetrics use?
11. What were the weaknesses of the hedge put on by Metallgesellschaft?
Chapter 7, page 51
Questions and exercises
1. Consider a firm that has a long exposure in the SFR for which risk, measured by CaR, is costly.
Management believes that the forward price of the SFR is low relative to the expected spot exchange
rate at maturity of the forward contract. Suppose that management is right. Does that necessarily
mean that the firms value will be higher if management hedges less than it would if it believed that
the forward price of the SFR is exactly equal to the expected spot exchange rate?
2. How would you decide whether the i.i.d. return model or the i.i.d. increment model is more
appropriate for the hedging problem you face?
3. Suppose that Metallgesellshaft had tenyear exposures and that the minimumvolatility hedge ratio
before tailing is 0.7. Assume that the 10year interest rate is 10%. What is the effective long position
in oil of Metallgesellschaft per barrel if it uses a hedge ratio of 1 per barrel? Does Metallgesellshaft
have a greater or lower exposure to oil prices in absolute value if it uses a hedge ratio of 1 or a hedge
ratio of 0?
4. A firm will receive a payment in one year of 10,000 shares of company XYZ. A share of company
XYZ costs $100. The beta of that company is 1.5 and the yearly volatility of the return of a share is
30%. The oneyear interest rate is 10%. The firm has no other exposure. What is the oneyear CaR
of this company?
Chapter 7, page 52
5. Using the data of question 4 and a market risk premium of 6%, what is the expected cash flow of
the company in one year without adjusting for risk? What is the expected riskadjusted cash flow?
6. Suppose the volatility of the market return is 15% and XYZ hedges out the market risk. What is
the CaR of XYZ after it hedges the market risk?
7. Suppose that the marginal cost of CaR is 0.001*CaR for XYZ and it costs 0.2 cents for each dollar
of the market portfolio XYZ sells short. Assuming that XYZ hedges up to the point where the market
cost of CaR equals the marginal cost of hedging, how much does XYZ sell short?
8. Suppose that in our example of hedging the world market portfolio, we had found that the t
statistic of the Nikkei is 1.1 instead. What would be your concerns in using the Nikkei contract in
your hedging strategy? Would you still use the contract to hedge the world market portfolio?
9. Suppose that you use the i.i.d. increment model when you should be using the return i.i.d. model.
Does your mistake imply that the VaR you estimate is always too low? If not, why not?
10. You hire a consultant who tells you that if your hedge ratio is wrong, your are better off if it is
too low rather than too high. Is this correct?
Chapter 7, page 53
Figure 7.1. Expected cash flow net of CaR cost as a function of hedge.
We use an expected spot exchange rate of $0.7102, a forward exchange rate of $0.6902, and a cost
of CaR of 0.0001 and 0.00001. With this example, hedging reduces the expected cash flow because
the spot exchange rate exceeds the forward exchange rate. Consequently, if " = 0, no hedging would
take place and the firm would go long on the forward market. The fact that risk is costly makes the
expected cash flow net of CaR a concave function of the hedge, so that there is an optimal hedge. As
" falls, the optimal hedge falls also.
Chapter 7, page 54
Figure 7.2. Marginal cost and marginal gain from hedging.
We use an expected spot exchange rate of $0.7102, a forward exchange rate of $0.6902, and a cost
of CaR of 0.0001 and 0.00001. With this example, hedging reduces the expected cash flow because
the spot exchange rate exceeds the forward exchange rate. Consequently, if " = 0, no hedging would
take place and the firm would go long on the forward market. The fact that risk is costly makes the
expected cash flow net of CaR a concave function of the hedge, so that there is an optimal hedge. As
" falls, the optimal hedge falls also.
Chapter 7, page 55
Figure 7.3. Optimal hedge ratio as a function of the spot exchange rate and " " when the cost
of CaR is " "*CaR
2
.
We use a forward exchange rate of $0.6902.
Chapter 7, page 56
Figure 7.4. Short position to hedge Export Inc.s exposure.
The hedging period starts on March 1. Export Inc. receives a payment of SFR1m on June 1 and must
make a payment of SFR1m on November 1. The price on March 1 of a discount bond maturing on
June 1 is $0.96 and the price on June 1 of a discount bond maturing on September 1 is $0.92. The
optimal hedge ratio for an exposure of SFR1 is 0.94. March 1 is time 0 and September 1 is time 0.5.
Chapter 7, page 57
Figure 7.5. Normal and lognormal density functions.
The normal distribution has mean 0.1 and volatility 0.5. The logarithm of the lognormally distributed
random variable has mean 0.1 and volatility 0.5.
Chapter 7, page 58
Box 7.1. The costs of hedging and Daimlers FX losses.
In the first half of 1995, DaimlerBenz had net losses of DM1.56 billion. These losses were
the largest in the groups 109year history and were due to the fall for the dollar relative to the DM.
DaimlerBenz Aerospace (DASA) has an order book of SFR20 billion. However, 80% of that book
is denominated in dollar. Consequently, a fall in the dollar reduces the DM value of the order book.
The company uses both options and forwards to hedge. On December 31, 1994, Daimler
Benz group had DM23 billion in outstanding currency instruments on its books and DM15.7 billion
of interest rate instruments. Despite these large outstanding positions, it had not hedged large
portions of its order book. German accounting rules require the company to book all expected losses
on existing orders, so that DaimlerBenz had to book losses due to the fall of the dollar. Had Daimler
Benz been hedged, it would have had no losses.
The explanation the company gave for not being hedged highlights the importance of costs
of hedging as perceived by corporations. Some analysts explained the lack of hedging by their
understanding that DaimlerBenz had a view that the dollar would not fall below DM1.55. This view
turned out to be wrong since the dollar fell to SFR1.38. However, the company blamed its losses on
its bankers. According to Risk Magazine, DaimlerBenz did so claiming their forecasts for the
dollar/Deutschmark rate for 1995 were so diverse that it held off hedging large portions of its foreign
exchange exposure. It claims 16 banks gave exchange rate forecasts ranging from DM1.20 to
DM1.70 per dollar.
If a company simply minimizes the volatility of its hedged cash flow, it is completely
indifferent to forecasts of the exchange rate. However, to the extent that it has a forecast of the
exchange rate that differs from the forward exchange rate, it bears a cost for hedging if it sells the
Chapter 7, page 59
foreign currency forward at a price below what it expects the spot exchange rate to be. Nevertheless,
one would think that if forecasts differ too much across forecasters, this means that there is a great
deal of uncertainty about the future spot exchange rate and that, therefore, the benefits of hedging
are greater. This was obviously not the reasoning of DaimlerBenz. It is unclear whether the company
thought that it could hedge a forecasted depreciation or whether it was concerned about its inability
to pin down the costs of hedging.
Source: Andrew Priest, Daimler blames banks forex forecasts for losses, Risk Magazine 8, No.
10 (October 1995), p. 11.
Chapter 7, page 60
Technical Box 7.2. Derivation of the optimal hedge when CaR is costly.
To obtain equation (7.1.), assume that the firms cash flow consists of receiving nS units of spot at
some future date and selling h units of spot at the forward price of F per unit for delivery at the same
date. (The analysis is the same for a futures price G for a tailed hedge assuming fixed interest rates.)
With this notation, the expected cash flow net of the cost of CaR for an exposure of n and a hedge
of h is:
Expected cash flow net of cost of CaR = Expected income minus cost of CaR
= (n  h)E(S) + hF  "CaR
2
(Box 7.2.A)
This equation follows because we sell n  h units on the spot market and h units on the forward
market. Remember now that the CaR with a hedge h assuming that increments are normally
distributed is 1.65Vol((n  h)S) where S denotes the spot price at the delivery date. Substituting the
definition of CaR in the above equation, we have:
Expected cash flow net of cost of CaR = (n  h)E(S) + hF  "(1.65Vol((n  h)S))
2
(Box 7.2.B)
To maximize the expected cash flow net of the cost of CaR, we take the derivative with respect to
h and set it equal to zero (remembering that Vol((n  h)S) is equal to (n  h)Vol(S)):
E(S) + F + 2"1.65(n  h)Vol(S)*1.65Vol(S) = 0 (Box 7.2.C)
Chapter 7, page 61
h = n 
F  E(S)
2 1.65 Var(S)
2
% 8R
B
.
(8.11.)
R
GM,t
' 0.0007 % 0.965R
mt
% 0.472S
DM
& 0.353S
& 0.198R
B
(0.181) (11.300) (2.997) (&2.092) (&1.902).
(8.12.)
percentage change in interest rates for corporate bonds of maturities from 3 to 10 years. To test the
firms exposure to these factors, we estimate the following regression:
Where " is a constant, $ is the firm systematic risk, (, *, and 8 are the sensitivities to the rates
of change of the German mark, Japanese yen and US interest rates, respectively. The estimates (t
statistics in parentheses) are:
So, GM has significant exposures to the mark, to the yen, and to the level of US interest rates. A
depreciation of the yen relative to the US dollar decreases firm value. Also, an increase in the US
interest rates decreases firm value. Numerically, a 10% appreciation in the dollar relative to the yen
and the DM along with a 10% increase in interest rates leads to a decrease of 3.53% and 1.98% from
the yen and the interest rate, respectively, and an increase of 4.72% as a result of DM increase. This
results in a 0.61% decrease in the value of the firms equity.
The example of General Motors shows how we can analyze the exposure of a firm to various
financial prices by including these prices in a simple linear regression. A similar analysis could be
done with the inclusion of the firms input prices or any other factor that the analyst feels may be
important after evaluation of the firm and industry characteristics along with a pro forma analysis.
Careful examination of the results of the regression can assist the financial manager in determining
the proper risk management strategy for the firm.
Chapter 8, page 40
There are a few caveats about the use of the regression approach that must be kept in mind
before its implementation. First, the regression coefficients are based on past information and may
not hold for the firm in the future. For example, the world automotive industry went from a period
of relatively benign competition in the 1970s to a period of more intense competition beginning in the
early 1980s. This competitive change probably had some effect on the exposure of cash flows of GM
to the changes in the yen. Also, the sales in Europe became more significant over this period. This
means that this approach might have done a poor job of estimating exposures for the 1980s using
data from the 1970s. More recently, the DM has been replaced by the Euro. It may well be that GM
exposure to the Euro is different from its exposure to the DM.
Secondly, the firm may be exposed to more market risks than those used in the regressions.
To understand how much of the volatility in equity is explained by the market risks used in the
regression, we already know that we can use the R
2
of the regression. The R
2
of the second regression
is 35%. This shows that our risk factors explain slightly more than 1/3 of the variance of General
Motors stock. Further examination of the characteristics of the firm, including its financial position,
sourcing, marketing, and the competitive nature of the industry would be helpful in identifying
additional risk factors.
Finally, the above regressions assume a simple linear relation between the cash flows of the
firm and the financial risk factors. This may not be appropriate. The relation can also be nonlinear.
For instance, the interaction between two market risks can matter for firm value. Such a nonlinear
structure can be incorporated in the regression, but to know that it exists, one has to already have a
good understanding of the firms exposures.
Despite all these caveats, the regression approach provides a way to check ones
Chapter 8, page 41
understanding of a firms exposures. If our analytical approach tells us that an increase in the price
of the SFR affects a firm adversely and the regression approach tells us the opposite, it is reasonable
to ask some tough questions about the analytical approach. Going further, however, we can also use
the exposures from the regression approach as hedge ratios for the present value of the cash flows
since firm value is the present value of the firms cash flows.
Section 8.5. Simulation approaches.
Consider a firm whose current situation is quite different from the situation it faced in its
recent history. Consequently, historical exposures estimated through a multiple regression do not
correctly describe the exposures that will apply in the future. If future cash flows can be modeled in
the way that we modeled the cash flow of Motor Inc., the cash flow exposures can be obtained
analytically for each exchange rate. However, the problem with that approach is that generally one
cannot obtain a measure of the volatility of cash flow analytically because one generally does not
know the distribution of cash flow even though one knows the distribution of the exchange rate
changes. As a result, one cannot compute CaR analytically. To obtain CaR, one then has to use
simulations.
Lets consider the example of Motor Inc. studied in Section 8.3. where sales depend on the
exchange rate. In this case, we can solve for the quantity produced that maximizes cash flow using
the relation that the marginal cost of a car produced must equal its marginal revenue when production
is chosen optimally. With our assumptions, marginal revenue is $20,000y, where y is the pound price
of the dollar. This must equal 0.5*Quantity produced. Consequently, the quantity produced is
20,000y/0.5. We can then compute the cash flow as:
Chapter 8, page 42
Cash flow in pounds = Price*Quantity  Cost
= (20,000y)(20,000y/0.5)  10M  0.25(20,000y)
2
To compute CaR, we therefore need the
fifth percentile of the distribution of cash flow. Note,
however, that cash flow depends on the square of the exchange rate. We may not even know what
the distribution of the square of the exchange rate is, so that an analytical solution may not be
possible. The simplest way to get CaR is therefore to perform a Monte Carlo analysis. Such an
analysis generates realizations of a function of random variables from draws of these random variables
from their joint distribution. Consequently, if we know the distribution of the exchange rate, we can
generate squared values of the exchange rate without difficulty even if the squared exchange rate does
not have a statistical distribution to which we can give a name. As a result, instead of having a
historical sample, we have a simulated sample. These realizations can then be analyzed in the same
way that we would analyze an historical sample. To understand this approach, note that here cash
flow depends on a random variable, the exchange rate which we denote by y. We therefore first have
to identify the distribution of y. Having done this, we use a random number generator to draw values
of y from this distribution. For each drawing, we compute cash flow. Suppose we repeat this process
10,000 times. We end up with 10,000 possible cash flows. We can treat these cash flows as
realizations from the distribution of cash flow. This is like having a sample. If we repeat the process
more often, we have a larger sample. We can then use the sample to estimate the mean, volatility, and
the fifth percentile of cash flow. As we increase the number of drawings, we are able to estimate the
distribution of cash flow more precisely. However, an increase in the number of drawings means that
the computer has to work longer to create our sample. In the example considered here, this is not an
Chapter 8, page 43
issue, but this may be an important issue for more complicated cash flow functions.
In Section 8.3., we computed the volatility of cash flow assuming a volatility of the exchange
rate of 10% p.a. Lets assume that the current exchange rate is 0.5, that the return is distributed
normally, that its percentage volatility for two years is 14.14%, and that its mean is zero. We saw
earlier that if sales are constant, the CaR is 76.99M. Lets now see what it is if sales change so that
the cash flow function is the one we derived in the previous paragraph. In this case, we know the
distribution of y, since the exchange rate in two years is the current exchange rate plus a normally
distributed return with mean zero and volatility of 10%. We therefore simulate 0.5 + x*0.5, where
x is a normally distributed variable with mean zero and volatility of 0.10.
We perform a Monte Carlo simulation with 10,000 drawings. Doing this, we find that the
expected cash flow is 90.91M, that the volatility is 20.05M, and that the fifth percentile shortfall
is 30.11M. The distribution of the cash flows is given in Figure 8.4. Note first that the expected cash
flow is not 90M, which is the cash flow if the dollar costs half a pound, which is its expected value.
There are two reasons for the discrepancy. First, with the Monte Carlo simulation, we draw a sample.
Different samples lead to different results. The results are expected to differ less for larger samples.
Second, because the cash flow is a nonlinear function of the exchange rate, its expectation is not equal
to the cash flow evaluated at the expected exchange rate. We can compare these results to the case
discussed earlier where sales are constant. In that case, the volatility was 46.66M and the fifth
percentile was 76.99M. The fact that the firm adjusts sales as the exchange rate changes reduces
cash flow volatility and CaR sharply relative to the case where it cannot do so. This shows that
flexibility in production can itself be a risk management tool, in that the firm that can adjust
production has less risk than the one that cannot.
Chapter 8, page 44
The above example allowed us to show how to use the Monte Carlo method. This method
can be applied when there are multiple sources of risk as well and can handle extremely complex
situations where one would be unable to compute exposures analytically. Box 8.1.: Monte Carlo
Analysis Example: Motor Inc. B describes a Monte Carlo analysis in detail for a variant of Motor
Inc. This analysis involves exchange rates for a number of years in the future, cash flows that depend
on past and current exchange rates as well as on whether a competitor enters the market. After having
computed cash flows for each year in each simulation trial, we have the distribution of the cash flows
that obtains given the distribution of the risk factors. We can then relate cash flows to risk factors.
In particular, we can measure the covariance between a given years cash flows and the exchange rate
in that year. This allows us to obtain a hedge coefficient for that years cash flow like we did when
we used the regression approach. The difference between the regression approach and the approach
discussed here is that the regression approach assumes that the future is like the past. The Monte
Carlo approach assumes that the distribution of the risk factors in the future is the same as in the past.
It does not assume that the distribution of cash flows is the same as in the past. Consequently, the
Monte Carlo approach could be used for a firm that has no history. This would not be possible with
the regression approach.
In the example Monte Carlo analysis discussed earlier in this section as well as the one in the
box, we make a number of assumptions that limit how the firm can change its operations in response
to changes in risk factors. For instance, the firm cannot switch methods of production or cannot start
producing in another country. It is important to stress that the Monte Carlo approach is generally the
best method to deal with situations where the firm has more flexibility than we assume here in
adjusting its operations in response to changes in risk factors. For instance, the Monte Carlo approach
3
This example is cited in a recent controversial article on foreign exchange risk
management, Copeland and Joshi (1996).
Chapter 8, page 45
could be used to study a situation where a firm produces in one country if the exchange rate is lower
than some value and in another country if it has a higher value.
Section 8.6. Hedging competitive exposures.
We have now seen that foreign exchange changes affect firm value through a variety of
different channels. Firms often choose to focus on some of these channels, but not others. For
instance, they might be concerned about transaction exposure but not about competitive exposure.
Whether a firm concerned about transaction exposure only is right in doing so depends on why it is
concerned about risk. However, focusing on the wrong exposure can have dramatic implications for
a corporation. An oftcited example is the case of a European airline concerned about the volatility
of its cash flow.
3
It therefore decides to hedge its transaction exposure. Its most important transaction
is an order of planes from Boeing. The payment will have to be made in dollars. The company
interprets this to mean that the firm is short dollars and hedges by buying dollars forward. During the
period of time that the hedge is maintained, the dollar depreciates and the airline gets in financial
trouble despite being hedged.
What went wrong? The prices that the airline charges are fixed in dollars because of the
structure of the airline market. Hence, if the dollar falls, the airline loses income in its home currency.
This does not correspond to booked transactions when the firm decides on its risk management
policy, so that focusing on transaction exposure, the airline forgot about the exposure inherent in its
operations. Because of the airlines blindness to its competitive exposure, its risk management policy
was inadequate. Had the firm taken into account its competitive exposure, it could have hedged its
Chapter 8, page 46
cash flow effectively.
The airline company example makes it clear that hedging transaction exposure does not hedge
cash flow. For this company, the impact of exchange rate changes on the firms competitive position
is immediate. The firm cannot raise ticket prices denominated in dollars, so that it receives less
income. The firm could have hedged so that it can keep selling tickets at constant dollar prices and
keep its hedged income unaffected by the change in the exchange rate. However, hedging to keep
activities unchanged as exchange rates change does not make sense and raises important questions
about hedging competitive exposure. Suppose that the airline hedged its competitive exposure. The
exchange rate changes, so that at the new exchange rate, the airline is not as profitable before the
income from hedging as it was before. Consequently, some flights that were profitable before may
no longer be so. Even though the airline is hedged, it does not make sense for the airline to continue
flights that are no longer profitable. This is because each unprofitable flight makes a loss. If the airline
stops the flight, it eliminates the loss. The fact that the airline makes money on its hedges is gravy 
it does not have to waste it on losing flights. Hence, the fact that the airline is hedged does not have
implications for its operations except insofar as the absence of hedging would prevent it from
maintaining flights that it views as profitable. For instance, it could be that if it had not hedged, it
would not have enough working capital and would be unable to fly profitable routes. In the case
of the airline discussed above, the competitive effects of changes in exchange rates manifest
themselves very quickly. In general, competitive effects take more time to affect a company and are
more subtle. Does it make sense to hedge competitive exposure and if yes, how? Suppose that a firm
has longterm debt and needs a minimum level of cash flow to make debt repayments. Adverse
developments in the firms competitive position due to exchange rate changes could make it
Chapter 8, page 47
impossible for the firm to make these debt repayments if it is not hedged and hence might force the
firm to incur bankruptcy and distress costs. Therefore, the arguments for hedging obviously provide
reasons to hedge competitive exposure. However, these arguments are not arguments for leaving
operations unaffected. A firm with low cash flow because of its unexpectedly poor competitive
position is a firm that has low internal funds to spend on new projects. One of these projects might
be to keep investing in the business with a poor competitive position because the situation is
temporary. However, it might be that the firm is better off to close the business with a poor
competitive position and invest in other operations.
One reason the firm might believe that the poor competitive position is temporary is that real
exchange rates are volatile and tend to move toward their purchasing power parity level in the long
run. Hence, the firms competitive position might change. Often, a firms activities in a country are
expensive to stop and start up later. The firm might therefore be better off to suffer shortterm losses
in a country rather than close its activities. If that is the case, however, it has to have the resources
to pursue such a strategy. It may not have these resources if it is not hedged because capital markets
might be reluctant to provide funds. This is because it might be quite difficult for capital markets
participants to understand whether a strategy of financing losing operations is profitable from a long
run perspective. At the same time, though, it is also easy for the firm to convince itself that financing
these operations is profitable when it is not.
Despite the importance of competitive exposure for the future cash flows of firms, a lot of
firms are content to hedge only transaction and contractual exposures with financial instruments.
When it comes to hedging economic exposure, if they do it at all, they turn to real hedges. A real
hedge means that one is using the firms operating strategy to reduce the impact of real exchange rate
Chapter 8, page 48
changes. For our car manufacturing company, a real hedge would mean having production in the US
as well as in the UK. This way it would still be able to sell profitably in the US market if the pound
appreciates because it could sell cars produced in the US. Such a strategy sometimes makes sense.
Suppose that by having facilities in the UK and the US the firm can quickly increase production where
it is cheapest to produce and decrease it where it is most expensive. This might be profitable
regardless of hedging in that the firms marginal production cost over time could be lower. However,
in general having production in different countries can be quite expensive since it involves large setup
costs, reduces economies of scale, and leads to higher management costs. In contrast, the transaction
and management costs of hedging with financial instruments are fairly trivial.
Section 8.7. Summary and conclusions.
In this section, we investigated the impact of quantity risks on the firms risk management
policies. We saw that quantity risks do not alter the formula for the optimal hedge with futures and
forwards, but the hedge differs when quantity is random from when it is not. Quantity risks make it
harder to figure out a firms exposure to a risk factor. We explored this issue extensively for foreign
exchange rate exposure. We saw in this case that exchange rate changes have a complicated impact
on firm value because they change revenue per unit as well as the number of units sold. We developed
three approaches that make it possible to figure out exposures when there are quantity risks. First,
the pro forma approach works from the cash flow statement and identifies directly how changes in
the exchange rate affect the components of cash flow. The problem with this approach is that it does
works well when the impact of exchange rate changes is straightforward. Otherwise, the exposure
cannot be identified and it is not possible to compute CaR. Second, we showed how multivariate
Chapter 8, page 49
regressions can help identify exposures in the presence of quantity risks. Third, we introduced the
Monte Carlo method as a way to estimate the impact of changes in risk factors and to compute CaR.
We saw that this method is quite versatile and makes it possible to estimate exposures when
alternative approaches do not work. We concluded with a discussion of the separation between
hedging and operating policies. The fact that a losing operation is hedged does not mean that one has
to keep it.
Chapter 8, page 50
Literature note
This chapter uses material in Stulz and Williamson (1997). The Stulz and Williamson (1997) paper
provides more details on some of the issues as well as more references. The problem of hedging
quantity and price risks is a longstanding problem in the hedging literature with futures. As a result,
it is treated in detail in most books on futures contracts. The formula we present is derived and
implemented in Rolfo (1980). The problem of hedging foreign currency cash flows is at the center
of most books on international corporate finance. An early but still convincing treatment of the issues
as well as a collection of papers is Lessard (1979). Shapiro ( ) provides a stateoftheart discussion.
However, international financial management books generally do not focus on the quantitative issues
as much as we do in this chapter. Levi ( ) has the best textbook analysis in terms of demand and
supply curves and is the inspiration for our discussion. Marston (1997) provides a careful analysis.
The discussion of exchange rate dynamics is basic material in international finance textbooks. A good
treatment can be found in Krugman and Obstfeld ( ), for instance. The regression approach has led
to a large literature. Adler and Dumas (1984) develop this approach as an exposure measurement
tool. Jorion (1990) is a classic reference. For references to more recent work and new results, see
Griffin and Stulz (2000). Williamson (2000) has a detailed analysis of exposures in the automotive
industry. His work underlies our analysis of GM. The role of real hedges has led to a number of
papers. Mello, Parsons, and Triantis (1995) have an interesting paper where they analyze hedging in
the presence of flexible production across countries. Logue (1995) has an article where he questions
hedging competitive exposures with financial instruments and Copeland and Joshi ( ) argue that
firms often hedge too much against changes in foreign exchange rates because of the diversification
effect discussed in chapter 7.
Chapter 8, page 51
Key concepts
Quantity risks, transaction exposure, contractual exposure, competitive exposure, cash flow delta to
a risk factor.
Chapter 8, page 52
Questions and exercises
1. An estimate by Goldman Sachs is that a 10% depreciation of the Japanese yen translates in a 2.5%
increase in the cost of Chinese exports in Chinese currency. How could that be?
2. Suppose that McDonalds hedges its current purchases of potatoes against an unancipated increase
in the price of potatoes, so that if the price of potatoes increases, it receives a payment equal to the
current purchases of potatoes times the change in the price of potatoes. How should an increase in
the price of potatoes affect the price of fries at McDonalds?
3. Suppose that purchasing power parity holds exactly. What would a 10% depreciation of the
Japanese yen that increases the cost of Chinese exports by 2.5% imply for prices in Japan and China?
4. How could a US car dealer in Iowa City that sells cars produced in the US by a US car
manufacturer have a competitive exposure to the Euro?
5. Consider a farmer who wants to hedge his crop. This farmer produces corn in Iowa. If his crop is
smaller than expected, then so is the crop of most farmers in the U.S. Should the farmer sell more or
less than his expected crop on the futures market? Why?
6. A wine wholesaler buys wine in France. He proceeds as follows: He goes on a buying trip in
France, buys the wines, and ships them to the US. When the wines arrive in the US, he calls up
Chapter 8, page 53
retailers and offers the wine for sale. There is a shipping lag between the time the wine is bought in
France and the time it arrives in the U.S. The wholesaler is concerned about his foreign exchange
exposure. His concern is that he has to pay for his purchases in French Franc when the wine arrives
in the US. Between the time the wine is bought in France and the time it is sold in the US, the French
Franc could appreciate, so that the wine becomes more costly in dollars. What are the determinants
of the cash flow exposure of the wholesaler to the dollar price of the French Franc?
7. Suppose you are a German manufacturer that competes with foreign firms. You find that your cash
flow is normally distributed and that for each decrease in the Euro price of the dollar by 1/100th of
a Euro, your cash flow falls by Euro1M. Yet, when the Euro appreciates, you sell fewer cars. How
do you hedge your cash flow? How does quantity risk affect your hedge?
8. Consider the analysis of Motor Inc. in Section 2. Suppose that Motor Inc. exports instead 11,000
cars to the US and 11,000 cars to Sweden. Lets assume that the price of a Swedish Krona in pounds
is the same as the price of a US dollar and the price of a car sold in Sweden is Kr20,000. We assume
now that the jointly normal increments model holds. The volatility of each currency is 0.10 pounds
per year. The two prices have a correlation of zero. What is the CaR in this case?
9. Lets go back to the base case discussed in the text where Motor Inc. exports 22,000 cars to the
US. Lets assume that half the costs of producing a car are incurred in dollars six months before the
sale and that all sales take place at the end of the calendar year. The US interest rate is 10% p.a. What
is Motor Inc.s exposure to the dollar?
Chapter 8, page 54
10. Assume that the volatility of the pound price of the dollar is 0.10 pound per year. What is the CaR
corresponding to the situation of question 9?
Chapter 8, page 55
Figure 8.1.B.
Dollars
Quantity
DD
MC
Q Q
MR
P
P
0
Before the depreciation of the dollar, the dollar price of cars sold in the U.S. is P and is given by the
point on the dollar demand curve DD corresponding to the quantity where the dollar marginal revenue
curve MR intersects the marginal cost curve MC. As the dollar depreciates, the marginal cost curve
moves to MC. The dollar price increases to P and the quantity exported falls to Q.
MC
Figure 8.1.A.
Pounds
Quantity
DD
MC
Q Q
MR
P
P
0
DD
MR
Before the depreciation of the dollar, the pound price of cars sold in the U.S. is P and is given by the
point on the demand curve DD corresponding to the quantity where the marginal revenue curve MR
intersects the marginal cost curve MC. As the dollar depreciates, the demand shifts to DD, the marginal
revenue curve shifts to MR. The price in pounds falls to P and the quantity exported falls to Q.
Chapter 8, page 56
Figure 8.2.B.
Dollars
Quantity
DD=MR
MC
Q
P
0
Before the depreciation of the dollar, the dollar price of cars sold in the U.S. is P and is given by the
point on the dollar demand curve DD corresponding to the quantity where the dollar marginal revenue
curve MR intersects the marginal cost curve MC. As the dollar depreciates, the dollar marginal cost
curve shifts upward to MC. Sales in the U.S. are no longer profitable.
MC
Figure 8.2.A
Pounds
Quantity
DD=MR
MC
Q
P
0
Before the depreciation of the dollar, the pound price of cars sold in the U.S. is P and is given by the
point on the demand curve DD corresponding to the quantity where the marginal revenue curve MR
intersects the marginal cost curve MC. As the dollar depreciates, the demand shifts to DD, the marginal
revenue curve shifts to MR. Sales in the U.S. are no longer profitable.
DD=MR
Chapter 8, page 57
Figure 8.3. Cash flow and exchange rate.
This figure gives the cash flow for Motor Inc. as a function of the pound price of the dollar. Cash
flow is a nonlinear function of the exchange rate. The delta foreign exchange rate exposure
measures the impact of a small increase in the exchange rate by using the slope of the cash flow
function. This approach is accurate for small changes in the exchange rate, but here for larger
increases it predicts a bigger fall in cash flow than actually occurs. If the exchange rate falls from
0.50 to 0.25, the loss predicted by the delta exposure of 400m is 100m, while the actual loss
predicted by the cash flow function is 75m.
Chapter 8, page 58
Distribution of Motor Inc.'s cash flow
0
0.02
0.04
0.06
0.08
0.1
0.12
0.14
0.16
2
8
4
3
.
0
4
7
3
5
8
.
0
9
4
7
7
3
.
1
4
2
8
8
.
1
8
9
4
1
0
3
.
2
3
7
1
1
8
.
2
8
4
1
3
3
.
3
3
1
1
4
8
.
3
7
9
1
6
3
.
4
2
6
Cash flow
P
R
O
B
A
B
I
L
I
T
Y
Figure 8.4. Distribution of Motor Inc.s cash flow.
The exchange rate is 0.5 for the dollar with a return volatility of 10% p.a. and zero mean.
Marginal revenue is $20,000 per car. The cash flows are obtained through a Monte Carlo
simulation with 10,000 draws using @Risk.
Chapter 8, page 59
Table 8.1.
Cash flow statement of Motor Inc. for 2000 (in million)
The dollar is assumed to be worth half a pound. The tax rate is
assumed to be 25%.
Sales in US
20,000 units at $20,000 each
200
Sales in UK
20,000 units at 10,000 each
200
Cost of sales (300)
Investment (50)
Taxes
0.25x(400300)
(25)
Net cash flow 25
Chapter 8, page 60
Box 8.1.: Monte Carlo Analysis Example: Motor Inc. B.
Motor Inc. B is a car producer in the UK. It has a vehicle in a market segment that it now
dominates in the UK and wants to expand its success to the US market. The firm is worried about
the impact of changes in the exchange rate on the net present value of the project. An analyst is
therefore asked to evaluate the exposure of the net present value of the project as well as the
exposure of each annual cash flow to the dollar/pound exchange rate. To evaluate the exposures the
analyst uses her knowledge of the costs of Motor Inc. B and of its competitive position in the US
market.
The demand function for the cars in the US is assumed to be:
Number of cars customers are willing to buy = 40,000  Dollar price of a car
The marginal cost of a car is 7,500 per unit and it is assumed to be constant over time. At an
exchange rate of $2 per pound, it is optimal for the firm to sell 25,000 cars at $15,000. The analyst
realizes that there is a strong possibility that a US producer will enter the market segment with a
comparable vehicle. This will have an effect on the pricing and thus the sales volume of Motor Inc.
B cars. The demand function with an entrant becomes:
Demand = 40,000  1.25*Dollar price of a car
Consequently, the entrant makes the demand for Motor Inc. B cars more sensitive to price. The
analyst believes that the probability that Motor Inc. B will face a competitor is 75% if the exchange
Chapter 8, page 61
rate exceeds $1.95 per pound and 50% otherwise. To sell in the US, Motor Inc. B has to spend
100m in 2001. It can then sell in the US starting in 2002. Depreciation is straight line starting in
2001 over five years. The tax rate on profits is 45% if profits are positive and zero otherwise. Motor
Inc. B fixes the dollar price of its cars at the end of a calendar year for all of the following calendar
year. The sales proceeds in dollars are brought back to the UK at the end of each calendar year at the
prevailing exchange rate.
This example includes nine random variables: whether an entrant comes in or not, and the
exchange rate for each calendar year from 2001 to 2009. Whether an entrant comes in or not is
distributed binomially with a probability of 0.75 if the exchange rate in 2001 exceeds 1.95. The
percentage change of the exchange rate from one year to the next is distributed normally with mean
of 2.2% and standard deviation of 14.35%. These random variables do not influence the present value
in a straightforward way. We argue in the text that the Monte Carlo analysis is particularly useful in
the presence of pathdependencies. In this case, there are two important path dependencies: first, the
cash flows depend on whether there is an entrant in 2001 which itself depends on the exchange rate;
second, the cash flow for one year depends on that years exchange rate as well as on the exchange
rate the year before.
We performed a Monte Carlo analysis using 400 trials. The output of the Monte Carlo
analysis can be used to understand the exposure of Motor Inc. B to the dollar/pound exchange rate
in many different ways. Here, we show two of these ways. First, the figure shows the relation
between the 2003 cash flow and the exchange rate in that year. At high exchange rates, it becomes
likely that the cash flow will be negative and there is a decreasing nonlinear relation between pound
cash flow and the dollar/pound exchange rate. Because of the path dependencies we emphasized, the
Chapter 8, page 62
2003 cash flow and exchange rate
50.00
0.00
50.00
100.00
150.00
200.00
250.00
300.00
350.00
400.00
$
0
.
8
5
$
1
.
2
2
$
1
.
3
7
$
1
.
4
6
$
1
.
5
7
$
1
.
6
6
$
1
.
7
3
$
1
.
7
9
$
1
.
9
1
$
2
.
0
0
$
2
.
1
0
$
2
.
2
4
$
2
.
4
0
$
2
.
6
0
$
2
.
9
6
Dollar price of pound
P
o
u
n
d
c
a
s
h
f
l
o
w
Figure Box 8.1. Motor Inc. B Corporation
This figure shows the relation between the pound cash flow in 2003 and the dollar price of the pound
in 2003 for the Motor Inc. B simulation. We draw four hundred different exchange rate series from
2001 to 2009. For each of these exchange rate series, we use the binomial distribution to obtain the
decision of whether a competitor enters the market or not. Based on the realization of the random
variables, we compute the cash flows from 2001 to 2009. The 2003 cash flows and their associated
2003 exchange rates are then plotted on the figure.
Chapter 8, page 63
cash flow depends on the exchange rate in earlier years also.
An alternative way to use the output of the Monte Carlo analysis is to regress the pound net
present value of the project (NPV) of selling in the US on the future exchange rates. This shows the
sensitivity of the net present value to future exchange rates. The NPV is measured in million pounds.
We get:
NPV = 1285  16.123X(2001)  144.980X(2002)  61.34X(2003)  39.270X(2004)
(28.95) (0.500) (4.382) (1.951) (1.245)
109.892X(2005)  42.596X(2006)  9.843X(2007)  82.941X(2008)  14.318X(2009)
(3.225) (1.230) (0.307) (2.509) (0.612)
where X(j) is the exchange rate in year j and tstatistics are in parentheses below the regression
coefficients. The Rsquared of this regression is 78%. Whereas the NPV is negatively related to all
exchange rates, not all future exchange rates are equally important determinants of the net present
value. This is not surprising. First, the net present value calculation puts less weight on the cash flows
that are received farther in the future. Second, our example has complicated path dependencies. Note,
however, that some exchange rates have an extremely large effect on the NPV. For instance, if the
2002 dollar price of the pound is unexpectedly higher by 10 cents, the NPV is lower by 14.5 million
pounds. The NPV obtained by averaging across 400 trials is 345 million. A 10 cents deviation in the
2002 exchange rate (about 4%) correspond to a change in the NPV of slightly more than 4%.
Chapter 9: Measuring and managing interest rate risks
Chapter objectives . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Section 9.1. Debt service and interest rate risks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3
Section 9.1.1. Optimal floating and fixed rate debt mix. . . . . . . . . . . . . . . . . . . . . . . 3
Section 9.1.2. Hedging debt service with the Eurodollar futures contract. . . . . . . . . . . 5
Section 9.1.3. Forward rate agreements. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11
Section 9.2. The interest rate exposure of financial institutions. . . . . . . . . . . . . . . . . . . . . . . . 12
Section 9.2.1. The case of banks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12
Section 9.2.2. Assetliability management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20
Section 9.3. Measuring and hedging interest rate exposures. . . . . . . . . . . . . . . . . . . . . . . . 22
Section 9.3.1. Yield exposure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23
Section 9.3.2. Improving on traditional duration. . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Section 9.4. Measuring and managing interest rate risk without duration. . . . . . . . . . . . . . . . 41
Section 9.4.1. Using the zero coupon bond prices as risk factors. . . . . . . . . . . . . . . 44
Section 9.4.2. Reducing the number of sources of risk: Factor models. . . . . . . . . . . 46
Section 9.4.3. Forward curve models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48
Section 9.5. Summary and conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53
Literature note . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
Key concepts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56
Review questions and problems . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57
Box 9.1. The tailing factor with the Eurodollar futures contract . . . . . . . . . . . . . . . . . . . . . . 59
Box 9.2. Orange County and VaR . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59
Box 9.3. Riskmetrics and bond prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61
Table Box 9.1. Riskmetrics mapping of cash flows . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63
Table 9.1. Eurodollar futures prices . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65
Table 9.2. Interest Rate Sensitivity Table for Chase Manhattan . . . . . . . . . . . . . . . . . . . . . . 67
Table 9.3. Example from Litterman and Scheinkman(1991) . . . . . . . . . . . . . . . . . . . . . . . . . 68
Figure 9.1. Example of a Federal Reserve monetary policy tightening . . . . . . . . . . . . . . . . . . 69
Figure 9.2. Bond price as a function of yield. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70
Figure 9.3. The mistake made using delta exposure or duration for large yield changes . . . . . 71
Figure 9.4. Value of hedged bank. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72
Figure 9.5.Term Structures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73
Table 9.1. Factor loadings of Swiss interest rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
Chapter 9: Measuring and managing interest rate risks
September 22, 2000
Ren M. Stulz 1998, 2000
Chapter 9, page 1
Chapter objectives
At the end of this chapter, you will:
1. Understand tradeoffs between fixed and floating rate debt for firms.
2. Be able to measure interest rate exposures.
3. Have tools to measure interest rate risks with VaR and CaR.
4. Have reviewed interest rate models and seen how they can be used to hedge and measure interest
rate risks.
Chapter 9, page 2
In 1994, interest rate increases caused a loss of $1.6 billion for Orange County and ultimately led
the county to declare bankruptcy. If Orange County had measured risk properly, this loss would most likely
never have happened. In this chapter, we introduce tools to measure and hedge interest rate risk. In one of
our applications, we show how these tools could have been used by Orange County. Much of our analysis
deals with how interest rate changes affect the value of fixed income portfolios, but we also discuss how
financial institutions as well as nonfinancial corporations can hedge interest rate risks associated with their
funding. Firms can alter their interest rate risks by changing the mix of fixed and floating rate debt they have.
We investigate the determinants of the optimal mix of floating and fixed rate debt for a firm and show how
a firm can switch from floating rate debt to fixed rate debt using a futures contract.
Financial institutions are naturally sensitive to interest rate risks. Remember that we use exposure
to quantify the sensitivity to a risk factor. Exposure of a security price to a risk factor is our estimate of the
change in the security price per unit change in the risk factor. We therefore review the determinants of the
exposure of financial institutions to interest rate changes and why these institutions care about this exposure.
Interest rate risks affect a firms cash flow as well as its value. As a result, some firms focus on the effect
of interest rate risks on cash flow whereas others are concerned about their effect on value. The techniques
to measure and manage the cash flow impact and the value impact of interest rate changes differ and are
generally used by different types of institutions. After reviewing these issues, we focus more directly on the
quantitative issues associated with the measurement and management of interest rate risks.
When measuring interest rate risk, a popular approach is to use duration. We will review how
duration is used, when it is and is not appropriate, and how one can do better than using duration. We also
Chapter 9, page 3
present approaches to measuring interest rate risk that do not rely on duration. In Chapter 4, we showed
how to estimate valueatrisk (VaR) in general. In this chapter, we present approaches to estimate VaR for
fixed income securities. However, fixed income securities differ widely in complexity. We will restrict our
attention mostly to fixed income securities without embedded options. Options as they relate to fixed income
securities will be studied in Chapter 14.
Section 9.1. Debt service and interest rate risks.
In this section, we first discuss the optimal mix of floating and fixed rate debt for a firm. We then turn
to using the Eurodollar futures contract to hedge the interest rate risks of floating rate debt. An alternative
financial instrument to hedge interest rate risks is a forward rate agreement (FRA). We explain this
instrument in the last part of the section.
Section 9.1.1. Optimal floating and fixed rate debt mix.
As we have already discussed, a firms choice of funding is part of its risk management strategy. An
allequity firm may be able to avoid risk management altogether. However, if equity is expensive relative to
debt, firms choose to have some debt and have to decide the mix of floating and fixed rate debt that is
optimal. Fixed rate debt does not contribute to the volatility of cash flow since it has constant payments. In
contrast, floating rate debt has variable payments indexed to an interest rate and may increase or decrease
the volatility of cash flow. Consider a firm with revenues that are higher when interest rates are high. Such
a firm has more variable cash flow if it finances itself with fixed rate debt than with floating rate debt. With
floating rate debt, the firm has high interest rate payments when its revenues are high. In contrast, a firm
Chapter 9, page 4
whose revenues fall as interest rates increase is in a situation where floating rate debt could lead to substantial
cash shortfalls since the firm might not be able to make interest payments when interest rates are high. Such
a firm might want to finance itself so that its interest rate payments are inversely related to the level of interest
rates.
It is important to understand that the debt maturity of a firm affects the interest rate sensitivity of its
cash flows. Fixed rate debt that matures in one year means that in one year the firm has to raise funds at
market rates. Hence, its cash flows in the future will depend on the rates it has to pay on this new debt. An
important issue with debt maturity is that the credit spread a firm has to pay can change over time as well.
A credit spread is the difference between the interest payment a firm has to promise and the payment it
would have to make if its debt were riskfree. This means that shortterm debt increases future cash flow
volatility because the firm might have to promise greater coupon payments in the future to compensate for
greater credit risk.
The tradeoffs we have just discussed imply that there is an optimal mix of fixed and floating rate
financing for a firm. Once a firm has financed itself, there is no reason for the mix to stay constant. If a firm
suddenly has too much floating rate debt, for instance, it can proceed in one of two ways. First, it can buy
back floating rate debt and issue fixed rate debt. Doing this involves floatation costs that can be substantial.
Second, the firm can hedge the interest rate risks of the floating rate debt. Having done this, the firm has
transformed the floating rate debt into fixed rate debt since the interest payments of the hedged debt do not
fluctuate. Often, hedging the interest rate risks of floating rate debt is dramatically cheaper than buying back
fixed rate issuing new floating rate debt.
A firm might want to use financial instruments to add interest rate risk to its debt service. For
Chapter 9, page 5
instance, a firm with fixed rate debt whose operating income was insensitive to interest rates finds that it has
become positively correlated with interest rates. That firm would have a more stable cash flow if it moved
from fixedrate debt to floatingrate debt since debt payments would then be positively correlated with
operating income. Rather than buying back fixed rate debt and issuing floating rate debt, the firm might be
better off using derivatives to change its debt service so that it looks more like the debt service of floating
rate debt than of fixed rate debt. Alternatively, a firm may be in a situation where some sources of funding
are attractive but using them would force the firm to take on interest rate risk it does not want. For instance,
nonUS investors find some tax advantages in buying dollar debt issued outside the US. In particular, such
debt is bearer debt, so that the owners of the debt are generally hidden from the fiscal authorities. As a result
of these tax advantages, American companies have been able to issue debt offshore at lower rates than
within the US. In extreme cases, American companies were even able to raise funds offshore paying lower
debt service than the US government on debt of comparable maturity. Access to offshore markets was
generally available only for wellknown companies. These companies therefore benefitted from taking
advantage of the lower cost financing. Yet, a company might have wanted to use floatingrate financing
which would not have been typically available on the offshore market for long maturity debt. Consequently,
after raising fixed rate funds abroad, the corporation would have to transform fixedrated debt into floating
rate debt.
Section 9.1.2. Hedging debt service with the Eurodollar futures contract.
Lets now look at how a firm would change the interest rate risks of its debt service. Consider a firm
that wishes to hedge the interest rate risks resulting from $100M of face value of floating rate debt. The
Chapter 9, page 6
interest rate is reset every three months at the LIBOR rate prevailing on the reset date. LIBOR stands for
the London InterBank Offer Rate. It is the rate at which a London bank is willing to lend Eurodollars to
another London bank. Eurodollars are dollars deposited outside the US and therefore not subject to US
banking regulations. US banking regulations are onerous to banks. In contrast, lending and borrowing in
Eurodollars is much less regulated. As a result, the Eurodollar market offers more advantageous lending and
borrowing rates than the domestic dollar market because the cost of doing business for London banks is
lower than for US domestic banks. In the 1960s and 1970s, though, the advantage of the London banks
was much higher than it is now. The LIBOR rate is provided by the British Bankers Association (
http://www.bba.org.uk/ ) through a designated information vendor. The designated information vendor polls
at least eight banks from a list reviewed annually. Each bank will contribute the rate at which it could
borrow funds, were it to do so by asking for and then accepting interbank offers in reasonable market size
just prior to 1100. for various maturities. The British Bankers Association averages the rates of the two
middle quartiles of the reporting banks for each maturity. The arithmetic average becomes the LIBOR rate
for that day published at noon, London time, on more than 300,000 screens globally.
Suppose that today, date t, the interest rate has just been reset, so that the interest rate is known
for the next three months. Three months from now, at date t+0.25, a new interest rate will be set for the
period from date t+0.25 to date t+0.5. As of today, the firm does not know which interest rate will prevail
at date t+0.25. LIBOR is an addon rate paid on the principal at the end of the payment period. The interest
payment for the period from date t+0.25 to date t+0.5 is 0.25 times the 3month LIBOR rate determined
on the reset date, date t+0.25, and it is paid at the end of the payment period, date t+0.5. If 3month
LIBOR at the reset date is 6%, the payment at t+0.5 is 0.25* 6%*100M, which is $1.5M. The general
Chapter 9, page 7
$100M*0.25*0.06
1 0.06 +
= $1.415M
Value of interest payment at beginning of payment period =
100M*0.25RL(t +0.25)
RL(t +0.25)) ( . 1 025 +
formula for the LIBOR interest payment is (Fraction of year)*LIBOR*Principal. LIBOR computations use
a 360day year. Typically, the payment period starts two business days after the reset date, so that the end
of the payment period with quarterly interest payments would be three months and two business days after
the reset date. The interest rate payment for the period from t+0.25 to t+0.5 made at date t+0.5 is equal
to the principal amount, $100M, times 0.25 because it corresponds to a quarterly payment, times LIBOR
at t+0.25, RL(t+0.25). To obtain the value of that payment at the beginning of the payment period, we have
to discount it at RL(t+0.25) for three months:
Using our numerical example with LIBOR at t+0.25 at 6%, we have:
To hedge the interest payment for the period from t+0.25 to t+0.5 at date t, we could think of using
a futures contract. The appropriate futures contract in this case is the Eurodollar contract. The Eurodollar
futures contract is traded on the International Money Market (IMM) of the Chicago Mercantile Exchange.
It is for a Eurodollar time deposit with threemonth maturity and a $1 million principal value. The futures
price is quoted in terms of the IMM index for threemonth Eurodollar time deposits. The index is such that
its value at maturity of the contract is 100 minus the yield on Eurodollar deposits. Cash settlement is used.
Chapter 9, page 8
The Eurodollar offered yield used for settlement is obtained by the IMM through a poll of banks. These
banks are not the same as those used by the British Bankers Association to obtain LIBOR, so that the
Eurodollar offered yield used for settlement is not exactly LIBOR. In our discussion, though, we ignore this
issue since it is of minor importance. Each basis point increase in the index is worth $25 to the long. Table
9.1. shows the futures prices on a particular day from the freely available 10 minute lagged updates on the
IMM web site (http://www.cme.com/cgibin/prices.cgi?prices/r_ed.html). An important characteristic of
Eurodollar futures is that they are traded to maturities of up to ten years.
To see how the contract works, suppose that we have a short position of $100M in the contract
expiring in four months quoted today at 95. If the contract matured today, the yield on Eurodollar deposits
offered would be 5% (10095 as a percentage of 100). The yield that would obtain if the contract matured
today is called the implied futures yield. In this case, the implied futures yield is 5%. Four months from now,
Eurodollar deposits are offered at 6%. In this case, the index at maturity of the contract is at 94. Since the
index fell and we are short, the settlement variation (the cash flows from marking the contract to market)
over the four months we held on to the position is 100 basis points annualized interest (6%  5%) for three
months applied to $100M. Hence, we receive 0.25*0.01*$100M, which amounts to $250,000. Now,
suppose that we have to borrow $100M at the market rate in four months for a period of three months. We
would have to pay interest for three months of 0.25*0.06*100M, or $1.5M. The interest expense net of
the gain from the futures position will be $1.5M  $0.25M, which is $1.25M and corresponds to an interest
rate of 5%. This means that the futures position allowed us to lock in the implied futures yield of 5%.
The only difficulty with the hedge we just described is that the futures settlement variation has been
completely paid by the time the futures contract matures. In contrast, the interest to be paid on the loan has
Chapter 9, page 9
to be paid at the end of the borrowing period of three months. Hence, as of the maturity of the futures
contract, the value of the interest payment is $1.5M discounted at LIBOR for three months whereas the
settlement variation on the futures contract is $0.25M. To obtain a more exact hedge, therefore, the futures
hedge should be tailed. The tailing factor discussed in Chapter 6 was a discount bond maturing at the date
of the futures contract. Here, however, because interest paid on the loan is paid three months after the
maturity of the futures contract, this means that we get to invest the settlement variation of the futures
contract for three more months. To account for this, the tailing factor should be the present value of a
discount bond that matures three months after the maturity of the futures contract. The details of the
computation of the tailing factor are explained in Box 9.1. The tailing factor with the Eurodollar
contract.
In our example, we were able to take floating rate debt and eliminate its interest rate risks through
a hedge. Consequently, the hedged floating rate debt becomes equivalent to fixed rate debt. For the
corporation, as long as there are no risks with the hedge, it is a matter of indifference whether it issued fixed
rate debt or it issued floating rate debt that it hedges completely against interest rate risks. The Eurodollar
futures contract enables the corporation to take fixed rate debt and make it floating as well. By taking a short
position in the Eurodollar futures contract, one has to make a payment that corresponds to the increase in
the implied futures yield over the life of the contract. Adding this payment to an interest payment from fixed
rate debt makes the payment a floating rate payment whose value depends on the interest rate. It follows
therefore that we can use the Eurodollar futures contract to transform fixed rate debt into floating rate debt
or vice versa. With this contract, therefore, the interest rate risk of the firms funding is no longer tied to the
debt the firm issues. For given debt, the firm can obtain any interest rate risk exposure it thinks is optimal.
Chapter 9, page 10
To understand how the futures contract is priced, we consider a portfolio strategy where we
borrow on the Euromarket for six months and invest the proceeds on the Euromarket for three months
and roll over at the end of three months into another threemonth investment. With this strategy, we bear
interest rate risk since the payoff from the strategy in six months increases with the interest rate in three
months which is unknown today. We can hedge that interest rate risk with the Eurodollar contract. If we
hedge the interest rate risk, our strategy has no risk (we ignore possible credit risk) and therefore its payoff
should be zero since we invested no money of our own.
To implement the strategy, we have to remember that the futures contract is for $1M notional
amount. Therefore, we can eliminate the interest rate risk on an investment of $1M in three months. The
present value of $1M available in three months is $1M discounted at the threemonth rate. Suppose that the
threemonth rate is 8% annually and the sixmonth rate is 10% annually. We can borrow for six months at
10% and invest the proceeds for three months at 8%. In three months, we can reinvest the principal and
interest for three months at the prevailing rate. With the 8% rate, the present value of $1M available in three
months is $980,392. We therefore borrow $980,392 for six months and invest that amount for three
months. In six months, we have to repay $980,392 plus 5%, or $1,029,412. To hedge, we short one Euro
dollar contract. Ignoring marking to market, the only way that we do not make a profit on this transaction
is if the Eurodollar futures contract allows us to lock in a rate such that investing $1M for three months at
that rate yields us $1,029,412. This corresponds to an annual rate of 11.765%. With this calculation, the
futures price should therefore be 100  11.765, or 88.235.
The price of the futures contract obtained in the last paragraph ignores markingtomarket, so that
departures from the price we have computed do not represent a pure arbitrage opportunity. Nevertheless,
Chapter 9, page 11
the example shows the determinants of the futures price clearly. Suppose that in three months the Eurodollar
rate is 15%. In that case, we lose money on our futures position. In fact, we lose 3.235/4 per $100 (15% 
11.765% for three months). We therefore invest in three months $1M  32,350/4/1.0375 for three months
at 3.75%. Doing that, we end up with proceeds of $1,029,412, which is what we would have gotten had
interest rates not changed. Our hedge works out exactly as planned.
Section 9.1.3. Forward rate agreements.
In contrast to the Eurodollar contract, forward rate agreements (FRAs) are traded over the counter.
A forward rate agreement is an agreement whereby the buyer commits to pay the fixed contract rate on
a given amount over a period of time and the seller pays the reference rate (generally LIBOR) at maturity
of the contract. The amount used to compute the interest payment plays the role of principal amount, but
it is not paid by anybody. Amounts used solely for computations are usually called notional amounts.
Consider the following example of a FRA. The contract rate is 10% on $10M notional starting in
two months for three months. With this contract, the buyer would pay the 10% and the seller would pay
threemonth LIBOR set in two months on $10M. The notional amount of $10M would not be exchanged.
With the FRA, the floating rate buyer locks in the borrowing rate. This is because in two months the buyer
pays 10% and receives LIBOR. Consequently, he can take the LIBOR payment and pass it on to the
lender. The payment from the FRA is computed so that in two months the required payment for the buyer
is the 10% annual payment in three months minus the payment at the reference rate discounted at the
reference rate for three months. This insures that the FRA is a perfect hedge. In other words, if the reference
rate is 8% in two months in our example, the payment in two months is 10% annual for three months (say
Chapter 9, page 12
91 days) minus 8% annual for the same period discounted at 8% annual for that period. This amounts to
(91/360)*0.02*10M/(1+(91/360)*0.08), or $49,553. Note that we divide by 360 days because the day
count for Eurodollars is based on 360 days. If the buyer has to make a floating rate payment based on the
rate in two months, he will have to pay 8% annual in five months or $202,222 (which is
0.08*(91/360)*10M). If the buyer borrows $49,553, he will have to pay back $50,556 in three months.
Hence, at that time, the buyers total payment will be $252,778. The payment on a $10M loan at 10% for
91 days is exactly the same amount. If it were not, there would be an arbitrage opportunity and the FRA
would be mispriced.
Section 9.2. The interest rate exposure of financial institutions.
Financial institutions can focus on measuring and hedging the impact of interest rate changes on their
earnings or on their portfolio value. We discuss these two approaches in this section. We then focus on
issues of implementation in the following two sections.
Section 9.2.1. The case of banks.
Lets look at a typical bank. It has assets and liabilities. Most of its liabilities are deposits from
customers. Its assets are commercial and personal loans, construction loans, mortgages and securities. This
bank faces interest rate risks as well as other risks. If interest rate risks are uncorrelated with other risks,
they can be analyzed separately from other risks. However, if they are correlated with other risks, then the
bank cannot analyze its interest rate risks separately from its total risk. Even if the bank has to consider its
total risk, it is helpful for it to understand its interest rate risks separately. Doing so can help it hedge those
Chapter 9, page 13
risks and understand the implications for the bank of changes in interest rates.
Suppose that interest rates increase. A measure of the impact of the increase in interest rates is how
it affects the banks income. Banks have generally used various exposure measures that tell them how their
net interest income (NII) is affected by changes in rates. If a bank keeps its holdings of assets and liabilities
unchanged, the only impact on NII has to do with changes in the interest payments of various assets. As
interest rates change, some assets and liabilities are affected and others are not. An asset or liability whose
interest payment changes during a period as a result of a change in interest rates either because it has a
floating rate or because it matures and is replaced by a new asset or liability with a market rate is said to
reprice during that period of time. The impact of the increase in interest rates on NII comes through the
repricing of assets and liabilities. The period of time over which the impact of the increase in interest rates
is computed determines which assets and liabilities are repriced. For instance, banks have fixed rate
mortgages outstanding whose interest rate payments are not affected by interest rate changes. They also
have deposits outstanding whose interest rate payments increase as interest rates increase. A bank with a
large portfolio of fixedrate mortgages financed by deposits with short maturities therefore experiences a fall
in its interest income as interest rates increase until its mortgage portfolio reflects the new interest rates. If
we look at the impact of an interest rate increase in the long run, it is much less than in the short run, because
new mortgages are written at the new rates. A bank whose liabilities reprice faster than the assets is called
liability sensitive. This is because the increase in interest rates increases the payments made to depositors
more than it increases payments received. Alternatively, it could be that the banks liabilities have a lot of
time deposits for one year and more, whereas its loans are floatingrate loans. In this case, the inflows might
Chapter 9, page 14
increase more than the outflows and the bank would be asset sensitive.
Why would the bank care about net interest income in this way? If none of the assets and liabilities
of the bank are marked to market, the impact of interest rate changes on net interest income is the only effect
of interest rate changes on accounting income and on the balance sheet assuming that the banks portfolio
stays constant. If the bank wants its earnings to be unaffected by interest rate changes and starts from a
position of being liability sensitive, it can do so through financial instruments. First, it could rearrange its
portfolio so that its assets are more interestrate sensitive. For instance, it could sell some of the fixed rate
mortgages it holds and buy floating rate assets or shortterm assets. Alternatively, it could take futures
positions that benefit from increases in interest rates. This would mean shorting interest rate futures contracts.
Remember from our discussion of the Tbond futures contract that interest rate futures contracts are similar
to forward purchases of bonds. An increase in interest rates decreases bond prices, so that the short position
benefits.
There exist a number of different approaches to measure the exposure of net interest income to
interest rate changes. The simplest and bestknown approach is gap measurement. The first step in gap
measurement is to choose a repricing period of interest. Consider a banks assets and liabilities. A new
thirtyyear mortgage does not reprice for thirty years if held to maturity in that the rate on that mortgage is
fixed for that period. In contrast, a onemonth CD reprices after one month. At any time, therefore, a bank
has assets and liabilities that reprice over different time horizons. Suppose we want to find out how the
banks income next month is affected by a change in interest rates over the current month. The only
payments affected by the change in rates are the payments on assets and liabilities that reprice within the
month. A deposit that reprices in two months has the same interest payments next month irrespective of how
Chapter 9, page 15
interest rates change over the current month. This means that to evaluate the interestrate sensitivity of the
banks interest income over the next month, we have to know only about the assets and liabilities that reprice
before the next month. Consider a bank with $100B in assets for which $5B assets and $10B liabilities
reprice before next month. $5B is a measure of the banks asset exposure to the change in rates and $10B
is a measure of the banks liability exposure to the change in rates. This bank has a net exposure to changes
in rates of $5B. The difference between a banks asset exposure and its liability exposure measure over
a repricing interval is called the banks dollar maturity gap. Alternatively, the gap can be expressed as a
percentage of assets. In this case, the bank has a percentage maturity gap of 5%.
Table 9.2. shows how Chase Manhattan reported gap information in its annual report for 1998. The
first row of the table gives the gap measured directly from the banks balance sheet. The gap from 1 to 3
months is $(37,879) million. The parentheses mean that between 1 and 3 months the banks liabilities that
reprice exceed the assets that reprice by $37,879M. Derivatives contracts that are not on the balance sheet
of the bank affect its interest rate exposure. Here, the derivatives increase the banks interest rate gap over
the next three months. As a result, the banks gap including offbalance sheet derivatives for that period is
$42,801M. Though the balancesheet gap at a short maturity is negative, it becomes positive for longer
maturities. The relevant gap measure if one looks at one year is the cumulative interest rate sensitivity gap
reported in the second row from the bottom. The cumulative interest rate sensitivity gap for 712 months
is $(37,506) million. This gap tells us that including all assets and liabilities that reprice within one year, the
bank has an excess of liabilities over assets of $37,506M.
The oneyear gap is an extremely popular measure. It measures assets and liabilities that will be
repriced within the year. It is important to understand the assumptions made when using such a gap measure.
Chapter 9, page 16
The gap measure is a static measure. It takes into account the assets and liabilities as they currently are and
assumes that they will not change. This can make the interest rate exposure measure extremely misleading.
To see this, lets go back to the example discussed above. Lets assume that $50B of the assets correspond
to fixed rate mortgages. The bank has a $5B gap. On an annual basis, therefore, a 100 basis points
decrease in rates would increase interest income by $50M since the banks income from assets would fall
by $50M and its interest payments on deposits would decrease by $100M. Now, however, new mortgage
rates are more attractive for existing borrowers. This makes it advantageous for borrowers to refinance their
mortgages. Suppose then that half of the mortgages are refinanced at the new lower rate which is 100 basis
points lower than the rate on existing mortgages. In this case, $25B of the mortgages are refinanced and
hence repriced. As a result, $25B of assets are repriced in addition to the $5B used in the gap measure.
Instead of having an exposure of $5B, the bank has an exposure of $20B. Using the gap measure would
therefore lead to a dramatic mistake in assessing the firms exposure to interest rates. If the bank hedged
its gap, hedging would add interest rate risk. To see this, note that to hedge the gap the bank would have
to go short interest rate futures so that it benefits from an increase in rates. The true exposure is such that
the bank makes a large loss when interest rates fall, so that it would have to be long in futures. By being
short, the bank adds to the loss it makes when interest rates fall. The additional complication resulting from
mortgages is, however, that the refinancing effect is asymmetric: the bank loses income if rates fall but does
not gain income if the interest rates increase. We will get back to the impact of such asymmetries on hedging
repeatedly.
Gap measures are static measures. They are therefore more appropriate for banks that have sticky
portfolios. For instance, suppose that the bank we discussed has a portfolio of 8% mortgages when market
Chapter 9, page 17
rates are at 12%. A 100basis points decrease in interest rates does not make it advantageous for
borrowers to refinance their mortgages. Some borrowers refinance because they are moving, but this is not
that important in this context. Consequently, in this case, a static measure may be a good indicator of interest
rate exposure. However, if instead market rates are 7.5%, a 100 basis point decrease may have a large
impact on refinancings. Though we used mortgages as our example of portfolio changes due to interest rate
changes, other assets and liabilities can be affected. For instance, consider an individual with a twoyear CD.
One month after buying the CD interest rates increase sharply. Depending on the early withdrawal provisions
of the CD, the individual may decide to withdraw his money and incur the penalty to reinvest at the new rate.
When using gap measures, it is therefore important to check whether using a static measure is really
appropriate to measure a banks exposure. Another important issue with the gap measure is that it presumes
that the change in interest rates is the same for all assets and liabilities that reprice within an interval. This
need not be the case. There can be caps and floors on interest payments that limit the impact of interest rate
changes. It can also be the case that some interest payments are more sensitive to rate changes than others.
For instance, the prime rate tends to be sticky and some floating rate payments can be based on sticky
indexes or lagging indexes.
There is a direct connection between a gap measure and a CaR measure. Consider our bank with
a gap of $5B. Suppose that the standard deviation of the interest rate is fifty basis points. If the rate is 5%
now and its changes are normally distributed, there is a 5% chance that the rate in one year will be greater
than 5% + 1.65*0.5%, or 5.825%. This means that there is a 0.05 probability of a shortfall in interest
income of 0.825%*5B for next year, or $41.25M. We can therefore go in a straightforward way from a
gap measure to a CaR based on gap that takes into account the distribution of the interest rate changes. This
Chapter 9, page 18
CaR makes all the same assumptions that gap does plus the assumption that interest rate changes are
normally distributed. We know how to compute CaR for other distributions usi