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Corporate Finance: Derivatives and Hedging Risk
Corporate Finance: Derivatives and Hedging Risk
Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-2
Chapter Outline
25.1 Forward Contracts
25.2 Futures Contracts
25.3 Hedging
25.4 Interest Rate Futures Contracts
25.5 Duration Hedging
25.6 Swap Contracts
25.7 Actual Use of Derivatives
25.8 Summary & Conclusions
Futures Markets
• The Chicago Mercantile Exchange (CME) is by far
the largest.
• In Canada:
– Montreal Futures Exchange (MFE)
– Winnipeg Commodity Exchange (WCE)
• Others include:
– The Philadelphia Board of Trade (PBOT)
– The MidAmerica Commodities Exchange
– The Tokyo International Financial Futures Exchange
– The London International Financial Futures Exchange
Canola Futures
• Expiry cycle: January, March, May, July,
September, November.
• First delivery day is the first business day of the
delivery month.
• Last trading day is seven clear business days prior
to the end of the delivery month.
• Trading hours 9:30 a.m. to 1:15 p.m. CT.
F C 1
PV 1 T
(1 r ) T
r (1 r )
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-22
C C C CF
PV
(1 r1 ) (1 r2 ) (1 r3 )
2 3
(1 r2T )T
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-23
Pricing of Forward Contracts
An N-period forward contract on that Government of
Canada Bond
Pforward C C C CF
…
0 N N+1 N+2 N+3 N+2T
Can be valued as the present value of the forward price.
Pforward
PV
(1 rN ) N
C C C CF
(1 rN 1 ) (1 rN 2 ) (1 rN 3 )
2 3
(1 rN 2T )T
PV
(1 rN ) N
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-24
Futures Contracts
• The pricing equation given above will be a good
approximation.
• The only real difference is the daily resettlement.
Duration Formula
Calculating Duration
Calculating Duration
Discount Present Years x PV
Years Cash flow factor value / Bond price
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
LIBOR – 0.125%
-10.375% + 10% + (LIBOR –
0.125%) = LIBOR – 0.5% which
Bank is 0.5% better than they can
10% borrow floating without a swap.
A
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
US$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Swap
Bank
US$9.4%
US$8%
£11% £12%
US$8% Firm Firm £12%
A B
US$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
£11% £12%
US$8% Firm Firm £12%
A B
A saves £.6%
US$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
£11% £12%
US$8% Firm Firm £12%
A B
£11% £12%
US$8% Firm At S0($/£) = $1.60/£, that Firm £12%
A is a gain of US$124,000 B
per year for 5 years. The swap bank
US$ £ faces exchange rate
Company A 8.0% 11.6% risk, but maybe
Company B 10.0% 12.0% they can lay it off
(in another swap).
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-50
Pricing a Swap
• A swap is a derivative security so it can be priced in
terms of the underlying assets:
• How to:
– Plain vanilla fixed for floating swap gets valued just like
a bond.
– Currency swap gets valued just like a nest of currency
futures.