Chapter 18 Managing Financial Risk with Derivatives

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Learning Objectives
basic difference between hedging and speculating.  Discern between hedging instruments including futures, options, swaps, and products such as interest rate ceiling, floor, and collars.  Develop appropriate interest rate hedging strategies.
 Understand the

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Hedging vs. Speculating

A

hedger has a cash position or an anticipated cash position that he or she is trying to protect from adverse interest rate movements

A

speculator has no operating cash flow position to protect and is trying to profit solely from interest rate movements

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Some Important Terms

 Hedger  Speculator  Perfect vs

imperfect hedge  Pure vs anticipatory hedge  Partial and cross hedge  Long (buy) and short (sell) hedge  Mark to market

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Hedger
An entity who uses the futures market to offset the price risks associated with his basic business activities. By assuming a position in the futures market that is equal and opposite to his position in the cash market, the hedger established a situation where losses in the cash market are offset by gains in the futures market and vice versa.
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Speculator
An entity who takes a position in the futures market that is not offset by an opposite position in a basic line of business.

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Perfect vs Imperfect Hedge

A perfect hedge is one where the individual is able to eliminate all risk of price fluctuations.

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Pure vs Anticipatory Hedge

A pure hedge is one where the individual assumes a position in the futures market equal and opposite to the current position in the cash market (such as hedging a riding the yield curve position). An anticipatory hedge is taking a position that is a temporary substitute for an anticipated position in the cash market.
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Partial and Cross Hedge

A partial hedge is where the person takes a position in the futures market that is smaller than the cash position.

A cross hedge is where the manager uses a different hedging instrument (futures instrument) than the hedged cash instrument.

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Long (buy) and Short (sell) Hedge

A long hedge is where the firm BUYS a futures contract. A short hedge is where the firm SELLS a futures contract. A long hedge is appropriate when the firm will buy an asset in the future or sell a liability prior to maturity. A short hedge is appropriate when the firm issues a liability in the future or sells a current cash position in the future.
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Mark to Market
Everyday the gain or loss on a futures position causes your margin account to be adjusted, gains or credited to your account and losses or debited.

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Hedging With Financial Futures

 Introduction  Buy

vs. sell hedge  Choosing the instrument  Choosing the expiration date  Choosing the number of contracts  Performance evaluation

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Introduction to Hedging w/Futures



A standardized contract that carries with it a performance obligation at expiration  Margin is generally required and is marked-tomarked-tomarket daily  WSJ Quotes Eurodollar (CME) - $1 mil.; pts of 100%
Open Open High Low Settle Chg Yield Chg Interest Mar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463

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Buy vs. Sell Hedge

 Type

of hedge should depend on the nature of the cash flow position being hedged, not on the anticipated direction of interest rates.  Buy Hedge: A future investment or retiring Hedge: a liability prior to maturity  Sell Hedge: Issue a liability in the future or Hedge: sell an investment prior to its maturity

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Choosing the Instrument

 Choice

of instrument should be consistent with the nature of the cash flow being hedged. interest rates should be highly correlated.

 The

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Choosing the Expiration Date

 Choose

the contract expiration month that occurs nearest to, but after, the date of the cash market transaction to be hedged.

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Choosing the Number of Contracts

Size of cash market instrument Maturity of cash market instrument N = ----------------------------------------- x ----------------------------------------------Futures contract denomination Maturity of futures contract instr.

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Performance Evaluation - Interest Rate Futures Hedge



Change in the value of the cash position Face value cash x (SR0 - SR1) x (Matc/360) Change in the value of the futures position Face value futures x (FR0 - FR1) x Matf/360) Commission cost Number of contracts x Commission rate Opportunity cost of the margin Number of contracts x MRG x (D x k/360)
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Performance Evaluation -Currency Futures Hedge



Change in the value of the spot market position Face value cash x (CX0 - CX1) = Gain (loss) spot Change in the value of the futures position Face value futures x (FX0 - FX1) = Gain (loss) futures Commission cost # contracts x Commission rate = Commission cost Opportunity cost of the margin # contracts x MRG x D x (k/360) = Margin cost
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Why Hedges Are Not Perfect

 Futures

contracts in general have only four expiration dates per year. (Note T-bills: TMar, June, Sept, and Dec.

 Correlation coefficient of

spot rates and futures rates is less than 1.0

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Hedging With Options

 Introduction  Type

of hedge: write or purchase, call or

put  Number of contracts  Performance evaluation

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Introduction to Options
A

call option contract gives the buyer the right to purchase the underlying asset at a specific price, the striking price, over a specific span of time. The buyer pays a premium for this right.  A put option allows the owner to sell the underlying asset at a specific price over a specific span of time. The buyer pays a premium for this right.  The options are on futures contracts for interest rate instruments
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Type of Hedge: Write or Purchase, Call or Put

a call futures option to hedge a future investment of cash or retire a liability before maturity.  Purchase a put futures option to hedge the future issue of liabilities or the future liquidation of financial assets.
 Purchase

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Number of Contracts
 The

number of options needed to purchase is based directly on the number of futures contracts needed. Refer to Equation 18-1. 18-

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Hedging With Swaps

 Introduction  Interest rate

swaps

Liability swap Asset swap

 Foreign currency swap

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Introduction

An interest rate swap occurs when two parties agree to exchange cash flow streams for a specified period of time. Swaps are different from options and futures in that they are not generally standardized and their maturities are usually for longer time periods than maturities of options and futures.

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Introduction to Swaps, continued

Interest rate swaps were created to take advantage of arbitrage opportunities in the various fixed- and floating-rate capital fixedfloatingmarkets. Arbitrage opportunities exist because some markets react to change more rapidly than others, because credit perceptions differ from market to market, and because receptivity to specific debt structures differs from market to market. If, for instance, a corporation wants term floating-rate floatingfunds but finds that the market for its fixed-rate debt is comfixedcomparatively cheaper than that for its floating-rate debt, then it floatingcan issue a fixed-rate bond and swap it into floating, for an fixedallall-in cost lower than that for a floating-rate bond or loan. floatingSource: The Government Securities Pink Book
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Other Details about Swaps

Amount: Amount: the base on which all interest payments are computed. This amount generally exceeds $25 million.  Risks: if the counterparty defaults Risks:  Direct Swap: an agreement between two Swap: parties without the involvement of a financial intermediary  Indirect Swap: the agreement is executed Swap: through an intermediary which may assume some of the credit risk.
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 Notional

Interest Rate Swap Diagram (Fixed-for(Fixed-for-Floating Liability Swap)

Borrows floating rate $ debt but desires fixed rate debt Counterparty A Floating Rate Interest Payments $ $ . . . . . . . $ $ Pays off floating rate $ debt principal at maturity Counterparty A A pays out fixed rate to B $ $ B pays out floating rate to A Counterparty B Borrows fixed rate debt but desires floating rate debt $ . . . . . . . $ $ $ $ Fixed Rate Interest Payments $ Counterparty B Pays off fixed rate debt principal at maturity 2005 by Thomson Learning, Inc. $ $ $ $ $ $ $ $ $ $

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Liability Swap
 k swap

= fr + so - si + fee

fr = financing rate so = swap outflow si = swap inflow fee = intermediary fee

 If

fr is fixed rate then so is floating and si is fixed If fr is floating then so is fixed and si is floating

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Asset Swap
 k swap

= ir - so + si - fee

ir = investment return so = swap outflow si = swap inflow fee = intermediary fee

 If

ir is floating rate then so is floating and si is fixed If ir is fixed rate then so is fixed and si is floating
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A Currency Swap Diagram

Borrows pounds sterling but swaps for dollars U. K. Company $ $ U. S. Company Borrows dollars and swaps for pounds sterling . . . . . . . $ $ $ $ $ $ U. S. Company ReRe-exchange for dollars and pays off debt Dollar Interest Payments ReRe-exchanges $ for pounds sterling and pays off debt U. K. Company

. . . . . . .

Pound Sterling Interest Payments

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Other Hedging Instruments



Interest rate caps

Purchaser pays a premium and receives cash payments from the cap seller when the reference rate exceeds strike rate. Cap payment = (ref - strk) x NP x L

Interest rate floors

Purchaser pays a premium for the rate floor contract, receives cash payment when reference rate falls below strike rate. Floor payment = (strk - ref) x NP x L

Interest rate collars

Purchase a rate cap and sell or issue a rate floor. Pay a premium for the cap and receive a premium for the floor. [Floor payment - Cap payment] Effective rate = REF + ----------------------------------------NP
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Summary
chapter began by discussing the difference between hedging and speculating.  The characteristics of different types of derivative instruments were presented.  Hedging strategies for each instrument were developed.  Each section concluded with a section on how to evaluate the performance of the hedge.
 The

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