RossCF9ce PPT Ch26

Chapter 26
Derivatives and Hedging Risk
Slides Prepared By:

Larbi Hammami
Desautels Faculty of Management
McGill University
© 2022 McGraw–Hill Education Limited

All Rights Reserved
5-2
12-2
8-2
Chapter Outline
26.1 Derivatives, Hedging, and Risk

26.2 Forward Contracts
26.3 Futures Contracts
26.4 Hedging
26.5 Interest Rate Futures Contracts
26.6 Duration Hedging
26.7 Swap Contracts
26.8 Actual Use of Derivatives
26.9 Summary and Conclusions
© 2022 McGraw–Hill Education Limited.

All Rights Reserved. 26-2
5-3
12-3
8-3
26.1 Derivatives, Hedging, and Risk

• Derivative - a financial instrument whose payoffs & values depend on something else.
– Derivatives are tools used by corporations to change a firm’s risk exposure.
• Hedging offsets the firm’s risk thereby reducing a firm’s exposure.
• Speculating is when a firm increases its exposure to a risk, in hopes of making a

profit.

5-4
12-4
8-4
26.2 Forward Contracts

• A forward contract specifies that a certain commodity will be exchanged for another
at a specified time in the future at prices specified today.
– It’s not an option: both parties are obligated to hold up their end of the deal.
– If you have ever ordered a textbook that was not in stock, you have entered into a
forward contract.

5-5
12-5
8-5

• A futures contract is like a forward contract: It specifies that a certain commodity
will be exchanged for another at a specified time in the future at prices specified
today.
• A futures contract is different from a forward: Futures are standardized contracts

trading on organized exchanges with daily resettlement (“marking to market”)
through a clearinghouse.
• Standardizing Features:
– Contract Size
– Delivery Month
• Netting out - a buyer (seller) can “net out” his futures position with a sale (with a
purchase).
• Daily resettlement - Marked to the market  Minimizes the chance of default and
requires extra liquidity by the firm
• Initial Margin  About 4% of contract value, cash or T-bills held by brokerage firm.
5-6
12-6
8-6
Example - Daily Resettlement

• Suppose you want to speculate on a rise in the CAN$/¥
exchange rate (specifically, you think that the dollar will
appreciate).
Currently CAN$1 = ¥140.

The 3-month forward price is CAN$1=¥150.
5-7
12-7
8-7
Example - Daily Resettlement (cont.)
• Currently CAN$1 = ¥140 and it appears that the CAN dollar is strengthening.
• If you enter into a three-month futures contract to sell ¥ at the rate of CAN$1 = ¥150
you will make money if the yen depreciates. The contract size is ¥12,500,000.
CAN $1
• Your initial margin is 4% of the contract value: CAN $3,333.33 = 0.04 × ¥12,500,000 ×
¥150
• If tomorrow, futures rate closes at CAN$1 = ¥149, then your position’s value drops.
• Your original agreement was to sell ¥12,500,000 and receive CAN$83,333.33:

CAN $1
CAN $83,333.33 = ¥12,500,000 ×
¥150
• But ¥12,500,000 is now worth CAN$83,892.62:
CAN $1
CAN $ 83,892.62=¥12,500,000 ×
¥149
• You have lost CAN$559.29 overnight.
5-8
12-8
8-8
Example - Daily Resettlement (cont.)
• The CAN$559.29 comes out of your CAN$3,333.33 margin account, leaving

CAN$2,774.04.
• This is short of the CAN$3,355.70 required for a new position:
¥12,500,000
• Your broker will let you slide until you run through your maintenance margin. Then
you must post additional funds or your position will be closed out. This is usually
done with a reversing trade.

5-10
12-10
8-10

Futures Markets
• The CME Group that owns the Chicago Mercantile Exchange (CME) and the Chicago Board of Trade (CBT)
is by far the largest.
• In Canada:
– Montreal Exchange (ME)
– Intercontinental Exchange (ICE) ICE Futures Canada (Winnipeg)
• Others include:
– Intercontinental Exchange (USA)
– The Tokyo International Financial Futures Exchange
– The London International Financial Futures and Options Exchange
Intercontinental Exchange - ICE Futures Canada
Canola Futures
• Expiry cycle: January, March, May, July, November
• First delivery day: the first business day of the delivery month.
• Last trading: trading day preceding the fifteenth calendar day of the delivery month.
5-11
12-11
8-11
Wall Street Journal Futures Price Quotes
Expiry month Closing

Opening price price Daily
Lowest price change
Highest price
that day that day Number of
open contracts
5-12
12-12
8-12
Basic Currency Futures Relationships
• Open interest refers to the # of contracts outstanding for a particular delivery month.
• Open interest is a good proxy for demand for a contract.
• Some refer to open interest as the depth of the market.
• The breadth of the market would be how many different contracts (expiry month,
currency) are outstanding.

5-13
12-13
8-13
26.4 Hedging
• Two counterparties with offsetting risks can eliminate risk.
– Ex: if a wheat farmer and a flour mill operator enter into a forward contract, they can eliminate
the risk each other faces regarding the future price of wheat.
• Hedgers can also transfer price risk to speculators & speculators absorb price risk from hedgers.
• Two types of hedges: Long vs. Short
• Short hedge - takes a short position in a futures c.&commits to a future selling price
• Long-hedge - takes a long position in a futures c.& commits to a future purchase price
• You speculate that copper increase in price, so you go long (commit to purchase copper) 10 copper
contracts for delivery in 3 months. A contract is for 25,000 lbs and price is quoted in cents per
pound. The price is US$0.70 per lb or US$17,500 per contract.
• If the futures price rises by 5 cents, you will gain  25,000 × 0.05 × 10 = US$12,500
• If the price decrease by 5 cents, your Loss  25,000 × –0.05 × 10 = -US$12,500

5-14
12-14
8-14
26.4 Hedging
Example - Short Position: How Many Contracts?
• You are a farmer and you will harvest 50,000 bushels of corn in three months. You want
to hedge against a price decrease. Corn is quoted in U.S. cents per bushel at 5,000
bushels per contract. It is currently at 460 cents for a contract three months out and the
current spot price is US$0.344/bushel.
50,000 bushels
• To hedge you will sell 10 corn futures contracts: =10 contracts
5,000 bushels per contract
• Now you can quit worrying about the price of corn and get back to worrying about the
weather.

5-15
12-15
8-15

• Pricing of Treasury Bonds
• Pricing of Forward Contracts
• Futures Contracts
• Hedging in Interest Rate Futures

5-16
12-16
8-16
Pricing of Treasury Bonds

• Consider a Government of Canada bond that pays a semiannual
coupon of $C for the next T years:
– The yield to maturity is r
C C C C+F
…
0 1 2 3 2T
• Value of the bond under a flat term structure
= PV of face value + PV of coupon payments
F
PV =
¿¿
5-17
12-17
8-17
Pricing of Treasury Bonds (cont.)

• If the term structure of interest rates is not flat, then we need to
discount the payments at different rates depending upon
maturity.
C C C C+F
…
0 1 2 3 2T
• Value of the bond under a non-flat term structure

C C
PV = +
(1 +r 1 ) ¿¿
5-18
12-18
8-18
Pricing of Forward Contracts
• An N-period forward contract on that Government of Canada Bond
−Pforward
C C C C+F
…
0 N N+1 N+2 N+3 N+2T
• Can be valued as the present value of the forward price.

P forward
PV =
¿¿
C C
PV = + ¿
(1 +r N +1 ) ¿¿
5-19
12-19
8-19
Example - Pricing of Forward Contract
• Find the value of a 5-year forward contract on a 20-year Government of Canada bond.
• The coupon rate is 6 percent per annum and payments are made semiannually on a par
value of $1,000.
• The quoted Yield to Maturity is 5 percent.

5-20
12-20
8-20
Example - Pricing of Forward Contract (cont.)
• First, compute the value of a 20-year T-bond at the maturity of the forward contract:
• The Effective Annual Yield to Maturity is:

(1.025)2 – 1 = 5.0625%
• Determine the price of the forward contract as PV of the bond price today (5 years
earlier):

5-21
12-21
8-21
Futures Contracts
• The pricing equation given in previous slide will be a good approximation of a futures
contract on this 20-year bond.
• Differences:
– The daily resettlement requirement of marked to the market.
– Delivery can take place any time within the delivery month.
– Due to liquidity in the market, the contract can be quickly netted out.

5-22
12-22
8-22
Hedging in Interest Rate Futures
• A mortgage lender who has agreed to loan money in the future at prices set today can
reduce the risk by selling those mortgages forward.
• It may be difficult to find a counterparty for the forward contract who wants the
precise mix of risk, maturity, and size.
• It’s likely to be easier and cheaper to use interest rate futures contracts to accomplish
the same result.

5-23
12-23
8-23
Duration Hedging
• As an alternative to hedging with futures or forwards, one can hedge by matching the
interest rate risk of assets with the interest rate risk of liabilities.
• Duration is the key to measuring interest rate risk.
• Duration measures the combined effect of maturity, coupon rate, and YTM on bond’s
price sensitivity.
– Measure of the bond’s effective maturity
– Measure of the average life of the security
– Weighted average maturity of the bond’s cash flows

5-24
12-24
8-24

Duration Formula
PV (C 1)×1+PV (C 2)×2+⋯+PV (CT )×T N

C t ×t
D= → D=∑ ¿¿
PV t=1
¿¿
Example - Calculating Duration
Calculate the duration of a three-year bond that pays a semi-annual coupon of $40, has
a $1,000 par value when the YTM is 8% semiannually.

5-25
12-25
8-25

• Duration is the key to bond portfolio management
• Properties:
– Longer maturity, longer duration
– Duration increases at a decreasing rate
– Higher coupon, shorter duration
– Higher yield, shorter duration
• Zero coupon bond: duration = maturity

5-26
12-26
8-26
26.7 Swap Contracts
Definitions
• In a swap, two counterparties agree to exchange cash flows at periodic intervals.
• There are two types of interest rate swaps:

– Single currency interest rate swap
• “Plain vanilla” fixed-for-floating swaps are often called interest rate swaps.
– Cross-currency interest rate swap
• Aka. currency swap; fixed for fixed rate debt service in 2 (or more) currencies.
The Swap Bank  is a generic term to describe a financial institution that facilitates
swaps between counterparties.
• The swap bank can serve as either a broker or a dealer.

– As a broker, the swap bank matches counterparties but does not assume any of the
risks of the swap.
– As a dealer, the swap bank stands ready to accept either side of a currency swap,
and then later lay off their risk, or match it with a counterparty.
5-27
12-27
8-27
26.7 Swap Contracts
Example - Interest Rate Swap (cont.)
• Consider this example of a “plain vanilla” interest rate swap.
• Bank A is a AAA-rated international bank located in the U.K. and wishes to raise
US$10,000,000 to finance floating-rate euro-dollar loans.
– Bank A is considering issuing five-year fixed-rate euro-dollar bonds at 10-percent.
– It would make more sense for the bank to issue floating-rate notes at LIBOR to
finance floating-rate euro-dollar loans.
• Firm B is a BBB-rated U.S. company. It needs US$10,000,000 to finance an

investment with a five-year economic life.
– Firm B is considering issuing five-year fixed-rate euro-dollar bonds at 11.75-
percent.
– Alternatively, firm B can raise the money by issuing five-year floating-rate notes
at LIBOR + 0.5 percent.
– Firm B would prefer to borrow at a fixed rate.

5-28
12-28
8-28
26.7 Swap Contracts

• The borrowing opportunities of the two firms are:

5-29
12-29
8-29
26.7 Swap Contracts

The swap bank makes this
Swap offer to Bank A: You pay
Bank LIBOR – 0.125% per year
10.375% on US$10 million for five
years and we will pay you
LIBOR – 0.125%
10.375% on US$10
Bank
million for five years.
A

5-30
12-30
8-30
26.7 Swap Contracts

0.5% of
US$10,000,000 = Swap Here’s what’s in it for Bank
US$50,000. A: They can borrow externally
That’s quite a cost Bank at 10% fixed and have a net
10.375% borrowing position of
savings per year
for five years. – 10.375% + 10% +
LIBOR – 0.125%
(LIBOR – 0.125%) =
Bank LIBOR – 0.5% which is 0.5%
10% better than they can borrow
A floating without a swap.

5-31
12-31
8-31
26.7 Swap Contracts

The swap bank makes
Swap
this offer to company
B: You pay us 10.5% Bank
per year on US$10 10.5%
million for five years
and we will pay you LIBOR – 0.25%
LIBOR – 0.25% per Company
year on US$10 million
B
for five years.

5-32
12-32
8-32
26.7 Swap Contracts
Example - Interest Rate Swap (cont.) 0.5 % of US$10,000,000

= US$50,000 that’s quite
Here’s what’s in it for Swap a cost savings per year for
B: Bank five years.
They can borrow externally at 10.5%
LIBOR + 0.5 % and have a net LIBOR – 0.25%

borrowing position of Company LIBOR
10.5 + (LIBOR + 0.5 ) – (LIBOR – 0.25 ) = + 0.5%
B
11.25% which is 0.5% better than they can borrow
floating.

5-33
12-33
8-33
26.7 Swap Contracts

0.25% of US$10 million
The swap bank Swap = US$25,000 per year
makes money for five years.
too. Bank
10.375% 10.5%
LIBOR – 0.125% LIBOR – 0.25%

Bank Company B
LIBOR – 0.125 – [LIBOR – 0.25]= 0.125
A 10.5 – 10.375 = 0.125
0.250

5-34
12-34
8-34
26.7 Swap Contracts

The swap
Swap
bank makes
Bank 0.25%
10.375% 10.5%
LIBOR – 0.125% LIBOR – 0.25%

Bank CompanyB
A
A saves 0.5% B saves 0.5%

5-35
12-35
8-35
26.7 Swap Contracts
Example - Currency Swap
• Suppose a Canadian multi-national company wants to finance a £10,000,000

expansion of a British plant.
• They could borrow dollars in the Canada where they are well known and exchange
dollars for pounds.
– This will give them exchange rate risk: financing a British pounds project with
CDN dollars.
• They could borrow pounds in the international bond market, but pay a premium since
they are not as well known abroad.
• If they can find a British multi-national company with a mirror-image financing need
they may both benefit from a swap.
• If the spot exchange rate is S0($/£) = CAN$1.60/£, the Canadian firm needs to
find a British firm wanting to finance dollar borrowing in the amount of
CAN$16,000,000.
5-36
12-36
8-36
26.7 Swap Contracts
Example - Currency Swap (cont.)
• Consider two firms A and B: firm A is a Canadian-based multinational and firm B is a

U.K-based multinational.
• Both firms wish to finance a project in each other’s country of the same size. Their
borrowing opportunities are given in the table below.

5-37
12-37
8-37
26.7 Swap Contracts

Swap
Bank
CAN$9.4%
CAN$8%
£11% £12%
CAN$8% Firm Firm £12%
A B

5-38
12-38
8-38
26.7 Swap Contracts
Example - Currency Swap (cont.) A’s net position is to

borrow at £11%
Swap
Bank
CAN$8% CAN$9.4%
£11% £12%
A B
A saves £.6%

5-39
12-39
8-39
26.7 Swap Contracts

B’s net position is
Swap to borrow at
Bank CAN$9.4%
CAN$8% CAN$9.4%
£11% £12%
A B
B saves $.6%

5-40
12-40
8-40
26.7 Swap Contracts
Example - Currency Swap (cont.) 1.4% of CAN$16

The swap bank million financed with
Swap 1% of £10 million per
makes money
Bank year for five years.
too:
CAN$8% CAN$9.4%
£11% £12%
CAN$8% Firm At S0($/£) = $1.60/£, that is Firm £12%
A a gain ofCAN$124,000 per B
year for 5 years.
The swap bank faces
exchange rate risk, but
maybe they can lay it
off (in another swap).
5-41
12-41
8-41
26.7 Swap Contracts
Variations of Basic Swaps
• Currency Swaps
– fixed for fixed
– fixed for floating
– floating for floating
– amortizing
• Interest Rate Swaps
– zero-for floating
– floating for floating
• Exotics  For a swap to be possible, two humans must like the idea. Beyond that,
creativity is the only limit.

5-42
12-42
8-42
26.7 Swap Contracts
Risks of Interest Rate and Currency Swaps
• Interest Rate Risk

– Interest rates might move against the swap bank after it has only gotten half of a
swap on the books, or if it has an unhedged position.
• Basis Risk
– If the floating rates of the two counterparties are not pegged to the same index.
• Exchange Rate Risk

– In the example of a currency swap given earlier, the swap bank would be worse
off if the British pound appreciated.

5-43
12-43
8-43
26.7 Swap Contracts
Risks of Interest Rate and Currency Swaps (cont.)
• Credit Risk  Major risk faced by a swap dealer - risk that a counter party will
default on its end of the swap.
• Mismatch Risk  It’s hard to find a counterparty that wants to borrow the same
amount of money for the same amount of time.
• Sovereign Risk  Risk that a country will impose exchange rate restrictions that will
interfere with performance on the swap.
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.

5-44
12-44
8-44
26.7 Swap Contracts
Credit Default Swap
• A credit default swap (CDS) is a contract that pays off when a credit event occurs -
default by a particular company, termed as the reference entity.
• The buyer of a CDS makes periodic payments to the seller. Upon the default of the
reference entity, the buyer has the right to sell the bonds issued by the reference entity
to the seller at full face value.
• Credit default swaps are a form of insurance against credit losses.

5-45
12-45
8-45
26.8 Actual Use of Derivatives

• Under IFRS, derivatives are recognized on the statement of financial position at their
fair value.
• Survey results appear to support the notion of widespread use of derivatives among:
– large publicly traded firms,
– Canadian multinational companies,
– non-regulated companies,
– gold and silver, paper and forest, pipelines, and agricultural companies.
– Derivatives are helpful in reducing a firm’s variability of cash flows.
• Foreign currency and interest rate derivatives are the most frequently used.


RossCF9ce PPT Ch26

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

RossCF9ce PPT Ch26

Uploaded by

Copyright:

Available Formats

Chapter 26

Derivatives and Hedging Risk

Slides Prepared By:

© 2022 McGraw–Hill Education Limited

26.1 Derivatives, Hedging, and Risk

© 2022 McGraw–Hill Education Limited.

26.1 Derivatives, Hedging, and Risk

– Derivatives are tools used by corporations to change a firm’s risk exposure.

• Hedging offsets the firm’s risk thereby reducing a firm’s exposure.

• Speculating is when a firm increases its exposure to a risk, in hopes of making a

© 2022 McGraw–Hill Education Limited.

26.2 Forward Contracts

© 2022 McGraw–Hill Education Limited.

26.3 Futures Contracts

• A futures contract is different from a forward: Futures are standardized contracts

26.3 Futures Contracts

Example - Daily Resettlement

Currently CAN$1 = ¥140.

26.3 Futures Contracts

Example - Daily Resettlement (cont.)

• Your original agreement was to sell ¥12,500,000 and receive CAN$83,333.33:

26.3 Futures Contracts

Example - Daily Resettlement (cont.)

• The CAN$559.29 comes out of your CAN$3,333.33 margin account, leaving

• This is short of the CAN$3,355.70 required for a new position:

© 2022 McGraw–Hill Education Limited.

26.3 Futures Contracts

Intercontinental Exchange - ICE Futures Canada

• Expiry cycle: January, March, May, July, November

26.3 Futures Contracts

Wall Street Journal Futures Price Quotes

Expiry month Closing

26.3 Futures Contracts

Basic Currency Futures Relationships

• Open interest is a good proxy for demand for a contract.

• Some refer to open interest as the depth of the market.

© 2022 McGraw–Hill Education Limited.

• Two types of hedges: Long vs. Short

© 2022 McGraw–Hill Education Limited.

© 2022 McGraw–Hill Education Limited.

26.5 Interest Rate Futures Contracts

• Pricing of Forward Contracts

• Hedging in Interest Rate Futures

© 2022 McGraw–Hill Education Limited.

26.5 Interest Rate Futures Contracts

Pricing of Treasury Bonds

26.5 Interest Rate Futures Contracts

Pricing of Treasury Bonds (cont.)

• Value of the bond under a non-flat term structure

26.5 Interest Rate Futures Contracts

Pricing of Forward Contracts

• An N-period forward contract on that Government of Canada Bond

• Can be valued as the present value of the forward price.

26.5 Interest Rate Futures Contracts

Example - Pricing of Forward Contract

• The quoted Yield to Maturity is 5 percent.

© 2022 McGraw–Hill Education Limited.

26.5 Interest Rate Futures Contracts

Example - Pricing of Forward Contract (cont.)

• The Effective Annual Yield to Maturity is:

© 2022 McGraw–Hill Education Limited.

26.5 Interest Rate Futures Contracts

© 2022 McGraw–Hill Education Limited.