Derivatives & Risk Management

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Introduction
Like options, forward and futures contracts
are derivative securities.
Derivative security is a financial security that is a
claim on another security or underlying asset.

Derivatives can be used to speculate on price
changes in attempts to gain profit or they can
be used to hedge against price changes in
attempts to reduce risk. In both cases, we
will compare strategies using options versus
using futures.
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Both forward and futures contracts lock in a
price today for the purchase or sale of
something in a future time period
E.g., for the sale or purchase of commodities
like gold, canola, oil, pork bellies, or for the sale
or purchase of financial instruments such as
currencies, stock indices, bonds.
Futures contracts are standardized and
traded on formal exchange; forwards are
negotiated between individual parties.
Forward and Futures Contracts
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Example of using a forward or
futures contract
COP Ltd., a canola-oil producer, goes long
in a contract with a price specified as $395
per metric tonne for 20 metric tonnes to be
delivered in September.
The long position means COP has a contract
to buy the canola. The payment of
$395/tonne 20 tonnes will be made in
September when the canola is delivered.
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Futures and Forwards
Unlike option contracts, futures and
forwards commit both parties to the
contract to take a specified action
The party who has a short position in the
futures or forward contract has
committed to sell the good at the
specified price in the future.
Having a long position means you are
committed to buy the good at the
specified price in the future.
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Futures and Forwards
No money changes hands between
the long and short parties at the
initial time the contracts are made
Only at the maturity of the forward or
futures contract will the long party pay
money to the short party and the short
party will provide the good to the long
party.
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The initial margin requirement
Both the long and the short parties
must deposit money in their
brokerage accounts.
Typically 10% of the total value of the
contract
Not a down payment, but instead a
security deposit to ensure the contract
will be honored

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Initial Margin Requirement
Example
Manohar has just taken a long position in a
futures contract for 100 ounces of gold to
be delivered in January. Magda has just
taken a short position in the same contract.
The futures price is $380 per ounce.
The initial margin requirement is 10%

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Marking to market
At the end of each trading day, all futures
contracts are rewritten to the new closing
futures price.
I.e., the price on the contract is changed.
Included in this process, cash is added or
subtracted from the parties brokerage
accounts so as to offset the change in the
futures price.
The combination of the rewritten contract and
the cash addition or subtraction makes the
investor indifferent to the marking to market
and allows for standardized contracts for
delivery at the same time to trade at the same
price.
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Hedging with Futures
For some business or personal reason, you
either need to purchase or sell the
underlying asset in the future.
Go long or short in the futures contract and
you effectively lock in the purchase or sale
price today. The net of the marking to
market and the changes in futures prices
results in you paying or receiving the
original futures price
I.e., you have eliminated price risk.
Types of Hedging
Long Hedge

Short Hedge

Cross Hedge
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Speculating with Futures
Speculating involves going long (or
short) in a futures contract when the
underlying asset is NOT needed to be
purchased (or sold) in the future time
period.
Enter into the contract, profit or lose due
to futures price changes and marking to
market, do an offsetting position to get
out of the contract and take the money
from the brokerage account.
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Should hedging or speculating be
done?
Speculating: If the market is informationally efficient,
then the NPV from speculating should be 0.
Hedging: Remember, expected return is related to
risk. If risk is hedged away, then expected return will
drop.
Investors wont pay extra for a hedged firm just
because some risk is eliminated (investors can easily
diversify risk on their own).
However, if the corporate hedging reduces costs that
investors cannot reduce through personal
diversification, then hedging may add value for the
shareholders. E.g., if the expected costs of financial
distress are reduced due to hedging, there should be
more corporate value left for shareholders.

What is an option?


The option is a right to buy 100 shares, or to
sell 100 shares.

Every option has four specific features:

1. It relates to a specific stock or other
security, called the underlying security.

2. It is a right to buy (call) or sell (put), and
every option controls 100 shares of stock.

3. A specific strike price is the fixed price
at which the option can be exercised.

4. Every option has a fixed expiration date.
After that date, the option is worthless.


Option an
intangible right
bought or sold
by a trader to
control 100
shares of a
security; it
expires on a
specific date in
the future.
Type of option
There are two types of options, calls
and puts.

A call grants its owner the right, but not the obligation, to
buy 100 shares of stock.

This right relates to a specific underlying security, at a
fixed strike price, and expires on a specified date in
the future.

Options can be bought (a long position) or sold (a short
position). When you sell an option, you grant the
option right to the person on the other side of the
trade.






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Option Premium
Option Premium primarily consists of two
components- Intrinsic Value and Time Value.
Option price/ premium= Intrinsic value + Time value
The intrinsic value of an option is equal to the amount
by which the option is in-the-money i.e. the amount
an option buyer will realize make (the option seller
will loose), before adjusting the premium, if he
exercises the option instantly
Only in-the-money options have intrinsic value and all
out-of-the-money or at-the-money options have zero
intrinsic value
Intrinsic value of an option can never be negative

Option Premium- Extrinsic Value
The time value of an option is the component which
takes care of future risk for seller of an option.
This value depends on time to expiration of the option
and volatility in the prices of the underlying asset
Mathematically, time value of an option is equal to
difference between option premium and its intrinsic
value
In case of out-of-the-money option or at-the-money
option, the entire premium is the time value of an option
Time value of an option cannot be negative
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What are the three steps of corporate
risk management?


1. Identify the risks faced by the firm.
2. Measure the potential impact of the identified
risks.
3. Decide how each relevant risk should be handled.

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What can companies do to minimize
or reduce risk exposure?
Transfer risk to an insurance company by paying
periodic premiums.
Transfer functions that produce risk to third parties.
Purchase derivative contracts to reduce input and
financial risks.
Take actions to reduce the probability of occurrence
of adverse events and the magnitude associated
with such adverse events.

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SWAP
SWAP is a derivative instrument in which counterparties exchange cash
flows of one party's financial instrument for those of the other party's
financial instrument.
Exchange of one security for another to change the maturity (bonds),
quality of issues (stocks or bonds), or because investment objectives have
changed.
If firms in separate countries have comparative advantages on interest
rates, then a swap could benefit both firms. For example, one firm may
have a lower fixed interest rate, while another has access to a lower
floating interest rate. These firms could swap to take advantage of the
lower rates.
TYPES
Currency swaps
Interest rate swaps
Credit swaps
Commodity swaps
Equity swaps
What is Currency SWAP
A swap that involves the exchange of principal and
interest in one currency for the same in another
currency.
For example, suppose a U.S.-based company needs to
acquire Swiss francs and a Swiss-based company needs
to acquire U.S. dollars. These two companies could
arrange to swap currencies by establishing an interest
rate, an agreed upon amount and a common maturity
date for the exchange.
FEATURES
Currency swaps are over-the-counter derivatives
and are closely related to interest rate swaps.
Unlike interest rate swaps, currency swaps can
involve the exchange of the principal.


USES
To secure cheaper debt (by borrowing at the
best available rate regardless of currency and
then swapping for debt in desired currency
using a back-to-back-loan)
To hedge against (reduce exposure to)
exchange rate fluctuations
Convert liability/investment from one currency
to another

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For example, a firm with fixed-rate debt that
expects interest rates to fall can change
fixed-rate debt to floating-rate debt.
In this case, the firm would enter into a pay
floating/receive fixed interest rate swap.
Interest Rate Swaps
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Bank A is a AAA-rated international bank located in the U.K.
that wishes to raise $10,000,000 to finance floating-rate
Eurodollar loans.

Bank A is considering issuing 5-year fixed-rate Eurodollar
bonds at 10 percent.
It would make more sense for the bank to issue floating-
rate notes at LIBOR to finance the floating-rate
Eurodollar loans.

Example
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Company B is a BBB-rated U.S. company. It needs
$10,000,000 to finance an investment with a five-year
economic life, and it would prefer to borrow at a fixed rate.
Firm B is considering issuing 5-year fixed-rate Eurodollar
bonds at 11.75 percent.
Alternatively, Firm B can raise the money by issuing 5-
year floating rate notes at LIBOR + percent.
Firm B would prefer to borrow at a fixed rate.
Example
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The borrowing opportunities of the two firms are shown in the
following table.

COMPANY B BANK A DI FFERENTI AL
Fixed rate 11.75% 10% 1.75%
Floating rate LIBOR + 0.50% LIBOR 0.50%

Example
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Bank A has an absolute advantage in borrowing relative to
Company B
Nonetheless, Company B has a comparative advantage in
borrowing floating, while Bank A has a comparative
advantage in borrowing fixed.
That is, the two together can borrow more cheaply if Bank A
borrows fixed, while Company B borrows floating.
Example