Hedging With Financial Derivatives

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Chapter 25

Hedging withFinancial

Derivatives



Copyright © 2009 Pearson Prentice Hall. All rights reserved. 25-2

Chapter Preview

Starting in the 1970s, the world became ariskier place f or financial institutions.

Interest rate volatility increased, as did thestock and bond markets. Financialinnovation helped with the development of derivatives. But if impr operly used,

derivatives can dramatically increase therisk institutions face.




Chapter Preview

In this chapter, we look at the most importantderivatives that managers of financial institutionuse to manage risk. We examine how the

markets f or these derivatives work and how thepr oducts are used by financial managers to reduce risk. Topics include:

± Hedging

± Forward Markets

± Financial Futures Markets




Chapter Preview (cont.)

± Stock Index Futures

± Options

± Interest-Rate Swaps

± Credit Derivatives




Hedging

Hedging involves engaging in a financialtransaction that reduces or eliminates risk.

Definitions ± long position: an asset which is purchasedor owned

± short position: an asset which must be

delivered to a third party as a future date, or anasset which is borr owed and sold, but must bereplaced in the future




Hedging

Hedging risk involves engaging in afinancial transaction that offsets a long

position by taking an additional shortposition, or offsets a short position by taking an additional long position.

We will examine how this is specifically accomplished in different financial markets.




Forward Markets

Forward contracts are agreements by two parties to engage in a financial transaction at afuture point in time. Although the contract can be

written however the parties want, the contactusually includes:

± The exact assets to be delivered by one party,including the location of deliver y

± The price paid f or the assets by the other party

± The date when the assets and cash will be exchanged




Forward Markets

An Example of an Interest-Rate Contract

± First National Bank agrees to deliver $5 million

in face value of 6% Treasur y bonds maturingin 2023

± Rock Solid Insurance Company agrees to pay $5 million f or the bonds

± FNB and Rock Solid agree to complete thetransaction one year fr om today at the FNBheadquarters in town




Forward Markets

Long Position

± Agree to buy securities at future date

± Hedges by locking in future interest rate of fundscoming in future, avoiding rate decreases

Short Position

± Agree to sell securities at future date

± Hedges by reducing price risk fr om increases ininterest rates if holding bonds




Forward Markets

Pr os

1. Flexible

Cons

1. Lack of liquidity: hard to find a counter-party and thin or non-existent secondar y market

2. Subject to default risk²requires inf ormationto screen good fr om bad risk




Financial Futures Markets

Financial futures contracts are similar to f orward contracts in that they are an

agreement by two parties to engage in afinancial transaction at a future point intime. However, they differ fr om f orwardcontracts in several significant ways.





Financial Futures Contract

1. Specifies deliver y of type of security at future date

2. Arbitrage: at expiration date, price of contract = priceof the underlying asset delivered

3. i o, long contract has loss, short contract has pr ofit

4. Hedging similar to f orwards: micro versus macro

hedge

Traded on Exchanges

± Global competition regulated by CFTC

Commodity Futures Options Trading,

Inc. home pagehttp://www.usafutures.com/




Example: Hedging Interest Rate Risk

A manager has a long position in Treasur y bonds. She wishes to hedge again interest

rate increases, and uses T-bond futures to do this:

± Her portf olio is worth $5,000,000

± Futures contracts have an underlying value of $100,000, so she must short 50 contracts.




Example: Hedging Interest Rate Risk

± As interest rates increase over the next 12months, the value of the bond portf olio dr opsby almost $1,000,000.

± However, the T-bond contract also dr oppedalmost $1,000,000 in value, and the short

position means the contact pays off that

amount. ± Losses in the spot T-bond market are offset by

gains in the T-bond futures market.





The previous example is a micr o hedge ±hedging the value of a specific asset.

Macr o hedges involve hedging, f or example, the entire value of a portf olio, or general prices f or pr oduction inputs.





In the U.S., futures are traded on theCBOT and the CME in Chicago, the NY

Futures Exchange, and others. They are regulated by the Commodity

Futures Trading Commission. The mostwidely traded are listed in the W all St reet

J ournal , as we see on the next slide.



25-17

Following the News





The U.S. exchanges dominated the marketf or years. However, this isn¶t trueanymore.

The London Int¶l Financial FuturesExchange trades Eur odollar futures

The Tokyo Stock Exchange trades

Eur oyen and gov¶t bond futures Several others as well, as seen next.



Widely Traded FinancialFutures Contracts





Success of Futures Over Forwards

1. Futures are more liquid: standardized

contracts that can be traded2. Deliver y of range of securities reduces the

chance that a trader can corner the market

3. Mark to market daily: avoids default risk

4. Don't have to deliver: cash nettingof positions




Hedging FX Risk

Example: A manufacturer expects to bepaid 10 million eur os in two months f or the

sale of equipment in Eur ope. Currently, 1eur o = $1, and the manufacturer would liketo lock-in that exchange rate.




Hedging FX Risk

The manufacturer can use the FX futuresmarket to accomplish this:

1. The manufacturer sells 10 million eur os of futures

contracts. Assuming that 1 contract is f or $125,000in eur os, the manufacturer takes as short position in40 contracts.

2. The exchange will require the manufacturer to

deposit cash into a margin account. For example,the exchange may require $2,000 per contract, or $80,000.




Hedging FX Risk

3. As the exchange rate fluctuates during thetwo months, the value of the margin accountwill fluctuate. If the value in the margin

account falls too low, additional funds may be required. This is how the market ismarked to market. If additional funds arenot deposited when required, the position

will be closed by the exchange.




Hedging FX Risk

4. Assume that actual exchange rate is 1 eur o = $0.96at the end of the two months. The manufacturer receives the 10 million eur os and exchanges them inthe spot market f or $9,600,000.

5. The manufacturer also closes the margin account,which has $480,000 in it²$400,000 f or the changesin exchange rates plus the original $80,000 requiredby the exchange (assumes no margin calls).

6. In the end, the manufacturer has the $10,000,000desired fr om the sale.




Stock Index Futures

Financial institution managers, particularly those that manage mutual funds, pension

funds, and insurance companies, also needto assess their stock market r isk, the riskthat occurs due to fluctuations in equity market prices.

One instrument to hedge this risk is stock

index futures.




Stock Index Futures

Stock index futures are a contract to buy or sella particular stock index, starting at a given level.Contacts exist f or most major indexes, including

the S&P 500, Dow Jones Industrials, Russell2000, etc.

The ³best´ stock futures contract to use isgenerally determined by the highest correlation

between returns to a portf olio and returns to aparticular index.




Hedging with Stock Index Futures

Example: Rock Solid has a stock portf olio worth $100 million, which tracks closely

with the S&P 500. The portf olio manager fears that a decline is coming and what to completely hedge the value of the portf olio over the next year. If the S&P is currently

at 1,000, how is this accomplished?





Value of the S&P 500 Futures Contract =250 v index

±

currently 250 x 1,000 = $250,000 To hedge $100 million of stocks that move

1 f or 1 (perfect correlation) with S&Pcurrently selling at 1000, you would:

± sell $100 million of index futures =400 contracts





Suppose after the year, the S&P 500 is at 900and the portf olio is worth $90 million.

± futures position is up $10 million

If instead, the S&P 500 is at 1100 and theportf olio is worth $110 million.

± futures position is down $10 million

Either way, net position is $100 million





Note that the portf olio is pr otected fr omdownside risk, the risk that the value in theportf olio will fall. However, to accomplish this,

the manager has also eliminated any upside potential.

Now we will examine a hedging strategy thatpr otects again downside risk, but does not

sacrifice the upside. Of course, this comes ata price!



25-31

Options

Options Contract

± Right to buy (call option) or sell (put option) an

instrument at the exercise (strike) price up untilexpiration date (American) or on expirationdate (Eur opean).

Options are available on a number of financial instruments, including individualstocks, stock indexes, etc.



25-32

Options

Hedging with Options

± Buy same number of put option contracts as would sellof futures

± Disadvantage: pay premium

± Advantage: pr otected if i , gain

if i

± Additional advantage if macr o hedge: avoidsaccounting pr oblems, no losses on option when i



Options




Factors Affecting Premium

1. Higher strike price, lower premiumon call options and higher premium onput options.

2. Greater term to expiration, higher premiums f or both call and put options.

3. Greater price volatility of underlyinginstrument, higher premiums f or both calland put options.





Example: Rock Solid has a stock portf olio worth $100 million, which tracks closely with the S&P 500. The portf olio manager

fears that a decline is coming and what to completely hedge the value of the portf olio against any downside risk. If the S&P iscurrently at 1,000, how is thisaccomplished?





Value of the S&P 500 Option Contract =100 v index

±

currently 100 x 1,000 = $100,000

To hedge $100 million of stocks that move1 f or 1 (perfect correlation) with S&P

currently selling at 1000, you would: ± buy $100 million of S&P put options =

1,000 contracts





The premium would depend on the strike price.For example, a strike price of 950 might have apremium of $200 / contract, while a strike price of

900 might have a strike price of only $100.

Let¶s assume Rock Solid chooses a strike price of 950. Then Rock Solid must pay $200,000 f or the

position. This is non-refundable and comes outof the portf olio value (now only $99.8 million).





Suppose after the year, the S&P 500 is at 900and the portf olio is worth $89.8 million.

± options position is up $5 million (since 950 strike price)

± in net, portf olio is worth $94.8 million

If instead, the S&P 500 is at 1100 and the

portf olio is worth $109.8 million. ± options position expires worthless, and portf olio is

worth $109.8 million





Note that the portf olio is pr otected fr om any downside risk (the risk that the value in the

portf olio will fall ) in excess of $5 million.However, to accomplish this, the manager has to pay a premium upfr ont of $200,000.




Interest-Rate Swaps

Interest-rate swaps involve the exchangeof one set of interest payments f or another

set of interest payments, all denominated inthe same currency.

Simplest type, called a plain vani lla swa p,specifies (1) the rates being exchanged,(2) type of payments, and(3) notional amount.



Interest-Rate Swap Contract Example

Midwest Savings Bank wishes to hedge ratechanges by entering into variable-rate contracts.

Friendly Finance Company wishes to hedge

some of its variable-rate debt with some fixed-rate debt.

Notional principle of $1 million

Term of 10 years

Midwest SB swaps 7% payment f or T-bill + 1%fr om Friendly Finance Company.




Interest-Rate Swap Contract Example




Hedging with Interest-Rate Swaps

Reduce interest-rate risk f or both parties

1. Midwest converts $1m of fixed rate assets to

rate-sensitive assets, R SA, lowers GAP

2. Friendly Finance R SA, lowers GAP




Hedging with Interest-Rate Swaps

Advantages of swaps

1. Reduce risk, no change in balance-sheet

2. Longer term than futures or options

Disadvantages of swaps

1. Lack of liquidity

2. Subject to default risk Financial intermediaries help reduce

disadvantages of swaps (but at a cost!)




Credit Derivatives

Credit derivatives are a relatively newderivative offering payoffs based onchanges in credit conditions along a variety of dimensions. Almost nonexistent twenty years ago, the notional amount of creditderivatives today is in the trillions.




Credit Derivatives

Credit derivatives can be generally categorized as credit options, credit swaps,and credit-linked notes. We will look ateach of these in turn.




Credit Derivatives

Credit options are like other options, butpayoffs are tied to changes in creditconditions.

± Credit options on debt are tied to changes incredit ratings.

± Credit options can also be tied to credit

spreads. For example, the strike price can bea predetermined spread between AAA-ratedand BBB-rated cor porate debt.




Credit Derivatives

Credit options are like other options, butpayoffs are tied to changes in creditconditions.

± Credit options on debt are tied to changes incredit ratings.

± Credit options can also be tied to credit

spreads. For example, the strike price can bea predetermined spread between BBB-ratedcor porate debt and T-bonds.




Credit Derivatives

For example, suppose you wanted to issue$100,000,000 in debt in six months, andyour debt is expected to be rated single-A.Currently, A-rated debt is trading at 100basis points above the Treasur y. Youcould enter into a credit option on the

spread, with a strike price of 100 basispoints.




Credit Derivatives

If the spread widens, you will, of course,have to issue the debt at a higher-than-expected interest rate. But the additionalcost will be offset by the payoff fr om theoption. Like any option, you will have to pay a premium upfr ont f or this pr otection.




Credit Derivatives

Credit swaps involve, f or example,swapping actual payments on similar-sizedloan portf olios. This allows financialinstitutions to diversif y portf olios while stillallowing the lenders to specialize in localmarkets or particular industries.




Credit Derivatives

Another f orm of a credit swap, called acredit default swap, involves option-likepayoffs when a basket of loans defaults.For example, the swap may payoff only after the 5th bond in a bond portf olio defaults (or has some other bad credit

event).




Credit Derivatives

Credit-linked notes combine a bond and acredit option. Like any bond, it makesregular interest payments and a finalpayment including the face value. But theissuer has an option tied to a key variable.




Credit Derivatives

For example, GM might issue a bond with a5% coupon rate. However, the covenantswould stipulate that if an index of SUVsales falls by more than 10%, the couponrate dr ops to 3%. This would be especially useful if GM was using the bond pr oceeds

to build a new SUV plant.




Are derivatives a time bomb?

In the 2002 annual report f or BerkshireHathaway, Warren Buffett referred to derivatives (bought f or speculation) as³«weapons of mass destruction.´ (althoughalso noting that Berkshire uses derivatives).Is he right?





There are three major concerns with theuse of financial derivatives:

± Derivatives allow financial institutions to

increase their leverage (effectively changingtheir capital), possibly to take on more risk

± Derivatives are too complicated

±

The derivative positions of some banks exceedtheir capital ± the pr obability of failure hasgreatly increased





As usual, the blanket comments are usually not accurate. For example, although thenotional amount of derivatives exceeds

capital, often these are offsetting positionson behalf of clients ± the bank has no exposure. In other words, you have to lookat each situation individually. Further,

actual derivative losses by banks is small,despite a few news-worthy exceptions.





In the end, derivatives do have their dangers. But so does hiring cr ooks to run abank (Lincoln S&L ring a bell). Butderivatives have changed the sophisticationneeded by both managers and regulatorsto understand the whole picture.




Chapter Summar y

Hedging: the basic idea of entering into anoffsetting contract to reduce or eliminatesome type of risk was presented.

Forward Markets: the basic idea of contracts in this highly specialized market,

as well as a simple example of eliminatingrisk was presented.




Chapter Summar y (cont.)

Financial Futures Markets: these exchangetraded markets were presented, as well astheir advantages over f orward contacts.

Stock Index Futures: the specificapplication of stock index futures was

presented, exploring their ability to reduceor eliminate risk f or equity portf olios.





Options: these contracts, which give thebuyer the right but not the obligation to act,were presented, as well as an exampleshowing their costs.

Interest-Rate Swaps: the idea of tradingfixed-rate interest payments f or floating-ratepayments was presented, as well as thepr os and cons of such contracts.




Credit Derivatives: we examine thisrelatively new market f or hedging the creditrisk of portf olios and the dangers involved.

Hedging With Financial Derivatives

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