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Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Chapter 18Chapter 18Managing Financial Risk with Managing Financial Risk with DerivativesDerivatives
OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent Cash PlacedPlaced Received Received Received Received Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >
Time ==>Time ==> Accounts Disbursement Accounts Disbursement
< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed
OrderOrder Order Order Sale Sale Payment Sent Cash Payment Sent Cash PlacedPlaced Received Received Received Received Accounts CollectionAccounts Collection < Inventory > < Receivable > < Float >< Inventory > < Receivable > < Float >
Time ==>Time ==> Accounts Disbursement Accounts Disbursement
< Payable > < Float >< Payable > < Float > Invoice Received Payment Sent Cash DisbursedInvoice Received Payment Sent Cash Disbursed
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Learning ObjectivesLearning Objectives
Understand the basic difference between Understand the basic difference between hedging and speculating.hedging and speculating.
Discern between hedging instruments Discern between hedging instruments including futures, options, swaps, and including futures, options, swaps, and products such as interest rate ceiling, floor, products such as interest rate ceiling, floor, and collars.and collars.
Develop appropriate interest rate hedging Develop appropriate interest rate hedging strategies.strategies.
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Hedging vs. SpeculatingHedging vs. Speculating
A A hedgerhedger has a cash position or an has a cash position or an anticipated cash position that he or she is anticipated cash position that he or she is trying to protect from adverse interest rate trying to protect from adverse interest rate movementsmovements
A A speculatorspeculator has no operating cash flow has no operating cash flow position to protect and is trying to profit position to protect and is trying to profit solely from interest rate movementssolely from interest rate movements
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Some Important TermsSome Important Terms
HedgerHedger SpeculatorSpeculator Perfect vs imperfect hedgePerfect vs imperfect hedge Pure vs anticipatory hedgePure vs anticipatory hedge Partial and cross hedgePartial and cross hedge Long (buy) and short (sell) hedgeLong (buy) and short (sell) hedge Mark to marketMark to market
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
HedgerHedger
An entity who uses the futures market to offset the price risksAn entity who uses the futures market to offset the price risks
associated with his basic business activities. By assuming a associated with his basic business activities. By assuming a
position in the futures market that is equal and opposite to hisposition in the futures market that is equal and opposite to his
position in the cash market, the hedger established a situationposition in the cash market, the hedger established a situation
where losses in the cash market are offset by gains in the where losses in the cash market are offset by gains in the
futures market and vice versa.futures market and vice versa.
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SpeculatorSpeculator
An entity who takes a position in the futures market An entity who takes a position in the futures market that is not offset by an opposite position in a basic line that is not offset by an opposite position in a basic line of business.of business.
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Perfect vs Imperfect HedgePerfect vs Imperfect Hedge
A A perfect hedge perfect hedge is one where the individual is able tois one where the individual is able to
eliminate all risk of price fluctuations. eliminate all risk of price fluctuations.
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Pure vs Anticipatory HedgePure vs Anticipatory Hedge
A A pure hedge pure hedge is one where the individual assumes a position in is one where the individual assumes a position in
the futures market equal and opposite to the current positionthe futures market equal and opposite to the current position
in the cash market (such as hedging a riding the yield curve in the cash market (such as hedging a riding the yield curve
position).position).
An An anticipatory hedge anticipatory hedge is taking a position that is a temporaryis taking a position that is a temporary
substitute for an anticipated position in the cash market.substitute for an anticipated position in the cash market.
Copyright Copyright 2005 by Thomson Learning, Inc. 2005 by Thomson Learning, Inc.
Partial and Cross HedgePartial and Cross Hedge
A A partial hedge partial hedge is where the person takes a position in theis where the person takes a position in the
futures market that is smaller than the cash position.futures market that is smaller than the cash position.
A A cross hedge cross hedge is where the manager uses a different hedgingis where the manager uses a different hedging
instrument (futures instrument) than the hedged cash instrument (futures instrument) than the hedged cash
instrument.instrument.
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Long (buy) and Short (sell) HedgeLong (buy) and Short (sell) Hedge
A A long hedge long hedge is where the firm BUYS a futures contract.is where the firm BUYS a futures contract.
A A short hedge short hedge is where the firm SELLS a futures contract.is where the firm SELLS a futures contract.
A long hedge is appropriate when the firm will buy an asset inA long hedge is appropriate when the firm will buy an asset in
the future or sell a liability prior to maturity.the future or sell a liability prior to maturity.
A short hedge is appropriate when the firm issues a liabilityA short hedge is appropriate when the firm issues a liability
in the future or sells a current cash position in the future.in the future or sells a current cash position in the future.
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Mark to MarketMark to Market
Everyday the gain or loss on a futures position causes yourEveryday the gain or loss on a futures position causes your
margin account to be adjusted, gains or credited to yourmargin account to be adjusted, gains or credited to your
account and losses or debited.account and losses or debited.
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Hedging With Financial FuturesHedging With Financial Futures
IntroductionIntroduction Buy vs. sell hedgeBuy vs. sell hedge Choosing the instrumentChoosing the instrument Choosing the expiration dateChoosing the expiration date Choosing the number of contractsChoosing the number of contracts Performance evaluationPerformance evaluation
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Introduction to Hedging w/FuturesIntroduction to Hedging w/Futures
A standardized contract that carries with it a A standardized contract that carries with it a performance obligation at expirationperformance obligation at expiration
Margin is generally required and is marked-to-Margin is generally required and is marked-to-market dailymarket daily
WSJ QuotesWSJ QuotesEurodollar (CME) - $1 mil.; pts of 100%Eurodollar (CME) - $1 mil.; pts of 100% OpenOpen
Open High Low Settle Chg Yield Chg Open High Low Settle Chg Yield Chg InterestInterestMar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463 Mar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463
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Buy vs. Sell HedgeBuy vs. Sell Hedge
Type of hedge should depend on the nature Type of hedge should depend on the nature of the cash flow position being hedged, not of the cash flow position being hedged, not on the anticipated direction of interest on the anticipated direction of interest rates.rates.
Buy HedgeBuy Hedge: A future investment or retiring : A future investment or retiring a liability prior to maturitya liability prior to maturity
Sell HedgeSell Hedge: Issue a liability in the future or : Issue a liability in the future or sell an investment prior to its maturitysell an investment prior to its maturity
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Choosing the InstrumentChoosing the Instrument
Choice of instrument should be Choice of instrument should be consistent with the nature of the cash consistent with the nature of the cash flow being hedged.flow being hedged.
The interest rates should be highly The interest rates should be highly correlated.correlated.
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Choosing the Expiration DateChoosing the Expiration Date
Choose the contract expiration month Choose the contract expiration month that occurs nearest to, but after, the date that occurs nearest to, but after, the date of the cash market transaction to be of the cash market transaction to be hedged.hedged.
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Choosing the Number of ContractsChoosing the Number of Contracts
Size of cash market instrument Maturity of cash market instrumentSize of cash market instrument Maturity of cash market instrumentN = ----------------------------------------- x -----------------------------------------------N = ----------------------------------------- x ----------------------------------------------- Futures contract denomination Maturity of futures contract instr. Futures contract denomination Maturity of futures contract instr.
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Performance Evaluation - Interest Performance Evaluation - Interest Rate Futures HedgeRate Futures Hedge
Change in the value of the cash positionChange in the value of the cash positionFace value cash x (SRFace value cash x (SR00 - SR - SR11) x (Mat) x (Matcc/360)/360)
Change in the value of the futures positionChange in the value of the futures positionFace value futures x (FRFace value futures x (FR00 - FR - FR11) x Mat) x Matff/360)/360)
Commission costCommission costNumber of contracts x Commission rateNumber of contracts x Commission rate
Opportunity cost of the marginOpportunity cost of the marginNumber of contracts x MRG x (D x k/360)Number of contracts x MRG x (D x k/360)
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Performance Evaluation -Currency Performance Evaluation -Currency Futures HedgeFutures Hedge
Change in the value of the spot market positionChange in the value of the spot market positionFace value cash x (CXFace value cash x (CX00 - CX - CX11) = Gain (loss) spot) = Gain (loss) spot
Change in the value of the futures positionChange in the value of the futures positionFace value futures x (FXFace value futures x (FX00 - FX - FX11) = Gain (loss) futures) = Gain (loss) futures
Commission costCommission cost# contracts x Commission rate = Commission cost# contracts x Commission rate = Commission cost
Opportunity cost of the marginOpportunity cost of the margin# contracts x MRG x D x (k/360) = Margin cost# contracts x MRG x D x (k/360) = Margin cost
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Why Hedges Are Not PerfectWhy Hedges Are Not Perfect
Futures contracts in general have only four Futures contracts in general have only four expiration dates per year. (Note T-bills: expiration dates per year. (Note T-bills: Mar, June, Sept, and Dec.Mar, June, Sept, and Dec.
Correlation coefficient of spot rates and Correlation coefficient of spot rates and futures rates is less than 1.0futures rates is less than 1.0
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Hedging With OptionsHedging With Options
IntroductionIntroduction Type of hedge: write or purchase, call or Type of hedge: write or purchase, call or
putput Number of contractsNumber of contracts Performance evaluationPerformance evaluation
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Introduction to OptionsIntroduction to Options
A A call option call option contract gives the buyer the contract gives the buyer the “right” to purchase the underlying asset at a “right” to purchase the underlying asset at a specific price, the striking price, over a specific specific price, the striking price, over a specific span of time. The buyer pays a premium for span of time. The buyer pays a premium for this right.this right.
A A put option put option allows the owner to sell the allows the owner to sell the underlying asset at a specific price over a underlying asset at a specific price over a specific span of time. The buyer pays a specific span of time. The buyer pays a premium for this right.premium for this right.
The options are on futures contracts for The options are on futures contracts for interest rate instrumentsinterest rate instruments
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Type of Hedge: Write or Purchase, Type of Hedge: Write or Purchase, Call or PutCall or Put
Purchase a call futures option to hedge a future Purchase a call futures option to hedge a future investment of cash or retire a liability before investment of cash or retire a liability before maturity.maturity.
Purchase a put futures option to hedge the Purchase a put futures option to hedge the future issue of liabilities or the future future issue of liabilities or the future liquidation of financial assets.liquidation of financial assets.
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Number of ContractsNumber of Contracts
The number of options needed to purchase The number of options needed to purchase is based directly on the number of futures is based directly on the number of futures contracts needed. Refer to Equation 18-1.contracts needed. Refer to Equation 18-1.
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Hedging With SwapsHedging With Swaps
IntroductionIntroduction Interest rate swapsInterest rate swaps– Liability swapLiability swap
– Asset swapAsset swap Foreign currency swapForeign currency swap
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IntroductionIntroduction
An interest rate swap occurs when two parties agree toAn interest rate swap occurs when two parties agree toexchange cash flow streams for a specified period of exchange cash flow streams for a specified period of time. Swaps are different from options and futures intime. Swaps are different from options and futures inthat they are not generally standardized and their that they are not generally standardized and their maturities are usually for longer time periods thanmaturities are usually for longer time periods thanmaturities of options and futures. maturities of options and futures.
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Introduction to Swaps, continuedIntroduction to Swaps, continued
Interest rate swaps were created to take advantage of arbitrageInterest rate swaps were created to take advantage of arbitrageopportunities in the various fixed- and floating-rate capital opportunities in the various fixed- and floating-rate capital markets. Arbitrage opportunities exist because some marketsmarkets. Arbitrage opportunities exist because some marketsreact to change more rapidly than others, because creditreact to change more rapidly than others, because creditperceptions differ from market to market, and becauseperceptions differ from market to market, and becausereceptivity to specific debt structures differs from market toreceptivity to specific debt structures differs from market tomarket. If, for instance, a corporation wants term floating-ratemarket. If, for instance, a corporation wants term floating-ratefunds but finds that the market for its fixed-rate debt is com-funds but finds that the market for its fixed-rate debt is com-paratively cheaper than that for its floating-rate debt, then itparatively cheaper than that for its floating-rate debt, then itcan issue a fixed-rate bond and swap it into floating, for an can issue a fixed-rate bond and swap it into floating, for an all-in cost lower than that for a floating-rate bond or loan.all-in cost lower than that for a floating-rate bond or loan.Source: The Government Securities Pink BookSource: The Government Securities Pink Book
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Other Details about SwapsOther Details about Swaps
Notional AmountNotional Amount: the base on which all : the base on which all interest payments are computed. This amount interest payments are computed. This amount generally exceeds $25 million.generally exceeds $25 million.
RisksRisks: if the counterparty defaults: if the counterparty defaults Direct SwapDirect Swap: an agreement between two : an agreement between two
parties without the involvement of a financial parties without the involvement of a financial intermediaryintermediary
Indirect SwapIndirect Swap: the agreement is executed : the agreement is executed through an intermediary which may assume through an intermediary which may assume some of the credit risk.some of the credit risk.
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Interest Rate Swap Diagram Interest Rate Swap Diagram (Fixed-for-Floating Liability Swap)(Fixed-for-Floating Liability Swap)
Counterparty ACounterparty A
Counterparty BCounterparty B
Counterparty ACounterparty A
Counterparty BCounterparty B
Borrows floating rateBorrows floating ratedebt but desires debt but desires $ $ $ $ $ $$ $ $ $ $ $fixed rate debtfixed rate debt
Pays off floating ratePays off floating ratedebt principal at debt principal at maturitymaturity
Borrows fixed rate Borrows fixed rate debt but desires debt but desires floating rate debtfloating rate debt
Pays off fixed ratePays off fixed ratedebt principal atdebt principal atmaturitymaturity
$ $ $ $ $ $$ $ $ $ $ $$ $ $ $ $ $$ $ $ $ $ $
Floating Rate Interest PaymentsFloating Rate Interest Payments
Fixed Rate Interest PaymentsFixed Rate Interest Payments$ $ $ $ $ $$ $ $ $ $ $
A A pays out fixed rate pays out fixed rateto to BB
BB pays out pays out floating rate to floating rate to AA
. . . . . . .
. . . . . . .
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Liability SwapLiability Swap
k k swapswap = fr + so - si + fee = fr + so - si + fee
fr = financing ratefr = financing rateso = swap outflowso = swap outflowsi = swap inflowsi = swap inflowfee = intermediary feefee = intermediary fee
If If frfr is fixed rate then is fixed rate then soso is floating and is floating and sisi is is fixedfixedIf If frfr is floating then is floating then soso is fixed and is fixed and sisi is floating is floating
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Asset SwapAsset Swap
kk swap swap = ir - so + si - fee = ir - so + si - fee
ir = investment returnir = investment returnso = swap outflowso = swap outflowsi = swap inflowsi = swap inflowfee = intermediary feefee = intermediary fee
If If irir is floating rate then is floating rate then soso is floating and is floating and sisi is is fixedfixedIf If irir is fixed rate then is fixed rate then soso is fixed and is fixed and sisi is is floatingfloating
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A Currency Swap DiagramA Currency Swap Diagram
U. K. CompanyU. K. Company
U. S. CompanyU. S. Company
U. K. CompanyU. K. Company
U. S. CompanyU. S. Company
Borrows poundsBorrows poundssterling but swapssterling but swapsfor dollarsfor dollars
Re-exchanges $ forRe-exchanges $ forpounds sterling and pounds sterling and pays off debtpays off debt
Borrows dollars Borrows dollars and swaps for and swaps for pounds sterlingpounds sterling
Re-exchange £ forRe-exchange £ fordollars and pays offdollars and pays offdebtdebt
$ $ $ $ $ $$ $ $ $ $ $£ £ £ £ £ ££ £ £ £ £ £
Dollar Interest PaymentsDollar Interest Payments
Pound Sterling Interest PaymentsPound Sterling Interest Payments
. . . . . . .
. . . . . . .
$$
££ $$
££
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Other Hedging InstrumentsOther Hedging Instruments
Interest rate capsInterest rate caps– Purchaser pays a premium and receives cash payments from Purchaser pays a premium and receives cash payments from
the cap seller when the reference rate exceeds strike rate.the cap seller when the reference rate exceeds strike rate.
– Cap payment = (ref - strk) x NP x LCap payment = (ref - strk) x NP x L
Interest rate floorsInterest rate floors– Purchaser pays a premium for the rate floor contract, Purchaser pays a premium for the rate floor contract,
receives cash payment when reference rate falls below strike receives cash payment when reference rate falls below strike rate.rate.
– Floor payment = (strk - ref) x NP x LFloor payment = (strk - ref) x NP x L
Interest rate collarsInterest rate collars– Purchase a rate cap and sell or issue a rate floor. Pay a Purchase a rate cap and sell or issue a rate floor. Pay a
premium for the cap and receive a premium for the floor.premium for the cap and receive a premium for the floor. [Floor payment - Cap payment] [Floor payment - Cap payment]
– Effective rate = REF + -----------------------------------------Effective rate = REF + ----------------------------------------- NP NP
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SummarySummary
The chapter began by discussing the difference The chapter began by discussing the difference between hedging and speculating.between hedging and speculating.
The characteristics of different types of The characteristics of different types of derivative instruments were presented.derivative instruments were presented.
Hedging strategies for each instrument were Hedging strategies for each instrument were developed.developed.
Each section concluded with a section on how Each section concluded with a section on how to evaluate the performance of the hedge.to evaluate the performance of the hedge.