Chapter 24

Fundamentals of
Corporate
Risk Management
Finance

Fifth Edition

Slides by
Matthew Will

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 2

Topics Covered

Why Hedge?
Reducing Risk with Options
Futures Contracts
Forward Contracts
Swaps
Innovation in the Derivatives Market
Is “Derivative” a Four-Letter Word?

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 3

Why Hedge?

Question of The Day

What is a cereal company in the business of
doing?
A. Producing a product efficiently and selling it for
a profit.
B. Speculating on the price of sugar, wheat, and other
inputs to its product.

Answer: Both

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 4

Why Hedge?

Question of The Day

The company does A. by choice and B. because
it has no choice.

The company can eliminate B through

Hedging

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 5

Reducing Risk With Options

Example - Onnex sells crude oil. Since its costs are
relatively fixed, fluctuations in the sale price of
crude oil can cause unexpected profits or losses.
How might Onnex hedge this risk?

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 6

Reducing Risk With Options

Example - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause
unexpected profits or losses.
How might Onnex hedge this risk?

Onnex’s loses
Revenues
money when
prices drop.

Price per barrel

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 7

Reducing Risk With Options

Example - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause
unexpected profits or losses.
How might Onnex hedge this risk?

A put option
Revenues
makes money
when prices drop.

Price per barrel

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 8

Reducing Risk With Options

Example - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause
unexpected profits or losses.
How might Onnex hedge this risk?

Onnex’s natural
risk, plus a put Revenues
option provides a
HEDGE against
price declines.

Price per barrel

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 9

Futures Contracts
Futures Contract - Exchange traded forward contract
with gains or losses realized daily.

Profit to seller
= initial futures price - ultimate market price

Profit to buyer
= ultimate market price - initial futures price

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 10

Future Contracts
Example - The Farmer’s Hedge - A farmer owns
wheat in her fields and wishes to hedge against a
drop in the price she will potentially sell it for in
the open market.
Show the positions involved in this hedge.

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 11

Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in
her fields and wishes to hedge against a drop in the price
she will potentially sell it for in the open market.
Show the positions involved in this hedge.

The farmer loses Value of wheat

money when the
price drops

Price per bushel

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 12

Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in
her fields and wishes to hedge against a drop in the price
she will potentially sell it for in the open market.
Show the positions involved in this hedge.

The futures Value of wheat

contract profits
when prices drop

Price per bushel

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 13

Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in
her fields and wishes to hedge against a drop in the price
she will potentially sell it for in the open market.
Show the positions involved in this hedge.

With a futures Value of wheat

contract the
farmer locks in a
price

Price per bushel

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 14

Financial Futures
Goal (Hedge) - To create an exactly opposite
reaction in price changes, from your cash position.

Commodities - Simple because assets types are

finite.

Financials - Difficult because assets types are

infinite.
You must attempt to approximate your position
with futures via “Hedge Ratios.”

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 15

Financial Futures

Future Exchange
U.S. Treasury notes CBT
U.S. Treasury bonds CBT
Eurodollar deposits IMM
Standard and Poor' s Index IMM
Euro IMM
Yen IMM
German Govt. Bond Eurex

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 16

Forward Contracts
Forward Contract - Agreement to buy or sell
an asset in the future at an agreed price.

 Forward contracts are “custom designed”

futures contracts. They have specific
amounts and expiration dates to meet the
buyers’ needs.

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 17

Swaps
Swap - Arrangement by two counterparties to
exchange one stream of cash flows for another.

Fixed rate pmt

LIBOR pmt
Company Swap Dealer
LIBOR pmt

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 18

Example - Interest Rate Swaps

Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%

Swap
Aaa Corp Borrows $1mil fixed loan @ 10%
BAA Corp Borrows $1mil variable loan @ 7.5%
Aaa assumes pmts on variable loan @ 7.5%
Baa assumes pmts on fixed loan @ 10.75%

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 19

Example - Interest Rate Swaps

Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%

Aaa Benefit
Pay Fix @ -10.00%
Get Fix @ +10.75%
Pay Var @ - 7.50%
Var Sav @ + 7.25%
Net Benefit + .50%

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 20

Example - Interest Rate Swaps

Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%

Aaa Benefit Baa Benefit

Pay Fix @ -10.00% Pay Var @ - 7.50%
Get Fix @ +10.75% Get Var @ + 7.50%
Pay Var @ - 7.50% Pay Fix @ -10.75%
Var Sav @ + 7.25% Fix Sav @ +11.50%
Net Benefit + .50% Net Benefit + .75%

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 21

Currency Swaps
Similar to interest rate swaps
Same type loan, just diff currency WHY?

example:
you have an investment in Japan
Project is financed with US bonds
You look for SWAP partner so you can emulate holding
Japanese bonds

Java Yahoo principal

Yen loan 11% 12% $ 1 mil
$ loan 8% 11.1% or Y120

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 22

Currency Swaps
example - cont

Java borrows $1mil @ 8%

Yahoo borrows Y120mil @ 12%
Intl. Bank arranges swap
Java swaps 8% $ loan for 10.3% yen loan w/bank
Yahoo swaps 12% yen loan for 10.4% $ loan w/bank

total available benefit = (11.1-8) - (12-11) = 2.1%

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 23

Currency Swaps
example - cont
benefit to Java
$ loan +8 - 8 = 0
Yen loan +11 - 10.3 = .7 net gain +.7%

benefit to Yahoo
$ loan 11.1 - 10.4 = +.7
yen loan -12 + 12 = 0 net gain = .7%

benefit to bank
$ loan +10.4 - 8 = +2.4
yen loan - 12 + 10.3 = -1.7 net gain + .7%

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
24- 24

Derivative Innovations
 The creative mind is the only barrier to new
derivative products. Even Weather
Derivatives have come into existence in
recent years.
Example: A TV network may
want to hedge the risk of a
World Series game being
rained out and thus they
forego advertising income.
Who might the counterparty
be to such a contract?

McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved