DERIVATIVES, AND RISK

MANAGEMENT, LEFT-HAND
FINANCING, AND LEVERAGED
BUYOUT
Group 1
Jerold Saddi
Pamela Bernabe
Juliet delos Santos
Jenelle Canonizado
Elvin Lee

Learning Objectives:

After this session the FINMAN students

would be able to:

Know all necessary concepts regarding

derivatives
Know all various left-hand financing schemes,
including their advantages and disadvantages
Know the mechanics of Leveraged buyout, its
use, its advantages and disadvantages

June 30, 2012

What are derivatives?

Are

financial instrument that

derive their value from
contractually required cash flows
from some other security or
index.

June 30, 2012

Example

http://www.youtube.com/watch?v=
FLGRPYAtReo

June 30, 2012

What are the essential

features of a derivative?

A derivative is a financial instrument

Values changes in response to the changes in

UNDERLYING variables.

No or minimum initial net investment

Settled at a future date by a net cash

payment / settlement

June 30, 2012

What are the kinds/examples

of derivatives?
Option Contract
Forward Contract
Futures Contract
Foreign Currency Exchange Contract
Interest Rate Swap

June 30, 2012

Accounting for Derivatives

Are to be considered as either assets or
liabilities and should be reported in the
balance sheet at fair value.
Unrealized gain or loss from fedging
transactions is presented depending on
the type of hedging.

Under the Fair Value hedge method part of

income
Under Cash Flow Hedge Method part of
EQUITY

June 30, 2012

For foreign entity

investment:

Changes in fair Value determined to be an

effective hedge are recognized in
EQUITY.
The ineffective portion of the changes in
fair value are recognized in EARNINGS
IMMEDIATELY if the hedging instrument is
a derivative.

June 30, 2012

Why do derivatives exist?

Hedging - Pertains to designating one or

more hedging instruments so that their
change in fair value is an offset, in whole
or in part, to the change in fair value or
cash flows of a hedged item.

http://www.youtube.com/watch?v
=kBtrxAjtG04

June 30, 2012

FORWARD CONTRACT

A transaction in which a seller agrees to

deliver a specific commodity to a buyer at
some point in the future.
Read more:
http://www.investorwords.com/2060/forw
ard_contract.html#ixzz1zDZdjqWa

June 30, 2012

Example

June 30, 2012

Call/ put Options

Financial Futures

June 30, 2012

Pamela Bernabe

OPTIONS

A derivatives financial instrument that specifies a

contract giving its owner the right to buy or sell an asset
at a fixed price on or before a given date.

Its

also a unique type of financial contract because they

give the buyer the right, but not the obligation, to do
something.

The

buyer uses the option only if it is adventageous to do

so; otherwise the option can be thrown away

Give

the marketplace opportunities to adjust risk or alter

income streams that would otherwise not be available

Provide
Can

financial leverage

be used to generate additional income from

investment
June 30, 2012 portfolios

LOW STRIKE

Thales ancient
Greek philosopher

June 30, 2012

OLIVE SEASON
HIGH

EXAMPLE
Supposedly

the first option buyer in the world was

the ancient Greek mathematician and philosopher
Thales of Miletus. On a certain occasion, it was
predicted that the season's olive harvest would be
larger than usual, and during the off-season he
acquired the right to use a number of olive
presses the following spring. When spring came
and the olive harvest was larger than expected he
exercised his options and then rented the presses
out at much higher price than he paid for his
'option'.
June 30, 2012

OPTION
TERMINOLOGY
Option Seller - One who gives/writes the option. He has an obligation
to perform, in case option buyer desires to exercise his option.

Option Buyer - One who buys the option. He has the right to exercise
the option but no obligation.

Call Option - Option to buy.

Put Option - Option to sell.

Call Option

Put Option

Option Buyer

Buys the right to buy the

underlying asset at the
Strike Price

Buys the right to sell the

underlying asset at the Strike
Price

Option Seller

Has the obligation to sell

the underlying asset to the
option holder at the Strike
Price

Has the obligation to buy the

underlying asset from the
option holder at the Strike
Price

June 30, 2012

OPTION TERMINOLOGY

American Option - An option which can be

exercised anytime on or before the expiry date.

Strike Price/ Exercise Price - Price at which the

option is to be exercised.

Expiration Date - Date on which the option expires.

European Option - An option which can be

exercised only on expiry date.

Exercise Date - Date on which the option gets

exercised by the option holder/buyer.

Option Premium - The price paid by the option

June 30, 2012

buyer to the option seller for granting the option.

CALL OPTIONS
A

call option gives you the right to buy

within a specified time period at a specified
price

The

owner of the option pays a cash

premium to the option seller in exchange
for the right to buy

June 30, 2012

PRACTICAL
EXAMPLE
OF A CALL OPTION

June 30, 2012

CALL OPTIONS ILLUSTRATION

An

investor buys one European Call option on one share of

Neyveli Lignite at a premium of Rs.2 per share on 31 July.
The strike price is Rs.60 and the contract matures on 30
September. It may be clear form the graph that even in the
worst case scenario, the investor would only lose a
maximum of Rs.2 per share which he/she had paid for the
premium. The upside to it has an unlimited profits
opportunity.
On the other hand the seller of the call option has a payoff
chart completely reverse of the call options buyer. The
maximum loss that he can have is unlimited though a profit
of Rs.2 per share would be made on the premium payment
2012
byJune
the 30,
buyer.

June 30, 2012

PUT OPTIONS
A

put option gives

you the right to sell
within a specified
time period at a
specified price

It

is not necessary to
own the asset before
acquiring the right to
sell it

June 30, 2012

 An

investor buys one European Put Option

on one share of Neyveli Lignite at a premium
of Rs. 2 per share on 31 July. The strike price
is Rs.60 and the contract matures on 30
September. The adjoining graph shows the
fluctuations of net profit with a change in the
spot price.

June 30, 2012

June 30, 2012

CALL/PUT OPTIONS
Call Option

Put Option

Option Buyer

Buys the right to buy the

underlying asset at the Strike
Price

Buys the right to sell the

underlying asset at the Strike
Price

Option Seller

Has the obligation to sell the

underlying asset to the option
holder at the Strike Price

Has the obligation to buy the

underlying asset from the option
holder at the Strike Price

June 30, 2012

STANDARDIZED
OPTION CHARACTERISTICS

All exchange-traded options have standardized

expiration dates
The

Saturday following the third Friday of designated

months for most options

Investors

typically view the third Friday of the month as

the expiration date
striking price of an option is the predetermined
transaction price
In multiples of $2.50 (for stocks priced $25.00 or
below) or $5.00 (for stocks priced higher than $25.00)

The

There

is usually at least one striking price above and

one
June
30,below
2012 the current stock price

STANDARDIZED
OPTION CHARACTERISTICS

Puts and calls are based on 100 shares of the

underlying security
The

underlying security is the security that the option

gives you the right to buy or sell

It

is not possible to buy or sell odd lots of options

June 30, 2012

FINANCIAL FUTURES
Forwards a contract that is customized between
two entities, where settlement takes place on a
specific date in the future at todays pre-agreed
price
Futures an agreement between two parties to
buy or sell an asset to a certain time in the
future at a certain price.
- it is also a special types of forward
contracts in the sense that the former
standardized exchange-traded contracts.
June 30, 2012

SIMPLE EXAMPLE

IfyouagreeinAprilwithyourAuntSuethatyouwillbuy

twopoundsoftomatoesfromhergardenfor$5,tobe
deliveredtoyouwhenthey'reripeinJuly,youandSuejust
enteredintoafuturescontract.
June 30, 2012

FINANCIAL FUTURES

A financial future is a futures contract on a short term

interest rate (STIR). Contracts vary, but are often
defined on an interest rate index such as 3-month
sterling or US dollar LIBOR.

They are traded across a wide range of currencies,

including the G12 country currencies and many others.

The assets often traded in futures contracts include

commodities, stocks, and bonds. Grain, precious metals,
electricity, oil, beef, orange juice, and natural gas are
traditional examples of commodities, but foreign
currencies, emissions credits, bandwidth, and certain
financial instruments are also part of today's commodity
markets.
June 30, 2012

FINANCIAL FUTURES
Some representative financial futures contracts are:
United States
90-day Eurodollar *(IMM)
1 mo LIBOR (IMM)
Fed Funds 30 day (CBOT)
Europe
3 mo Euribor (Euronext.liffe)
90-day Sterling LIBOR (Euronext.liffe)
Euro Sfr (Euronext.liffe)
Asia
3 mo Euro yen (TIF)

90-day Bank Bill (SFE)

where
IMM is the International Money Market of the Chicago Mercantile
Exchange
CBOT is the Chicago Board of Trade
TOCOM is the Tokyo Commodity Exchange

SFE is the Sydney futures exchange

June 30, 2012

COMPARISON OF
FUTURES AND
Futures
Forward
FORWARD
Amount
Delivery Date

Standardized
Standardized

Negotiated
Negotiated

Counter-party
Collateral

Clearinghouse
Margin Acct.

Bank
Negotiated

Market
Costs

Auction Market Dealer Market

Brokerage and Bid-ask spread
exchange fees

Liquidity
Regulation

Very liquid
Government

Highly illiquid
Self-regulated

June 30, 2012

Location

Central

Worldwide

ADVANTAGE AND
DISADVANTAGE OF
FINANCIAL
FUTURES
Advantages

Small Contract Size

Easy liquidation
Well organized and stable market (no risk of default)

Disadvantages

Limited number of currencies (but think about how one

futures might be a close hedge against another currency)
Rigid contract size
Fixed expiration dates (but if you can get close, it doesnt
matter all that much).

June 30, 2012

THERE ARE TWO TYPES OF

ORGANIZATIONS THAT FACILITATE
FUTURES TRADING:
Exchange
Exchanges are non-profit or for-profit
organizations that offer standardized futures
contracts for physical commodities, foreign
currency and financial products.
Clearinghouse
A clearinghouse is agency associated with an
exchange, which settles trades and regulates
delivery. Clearinghouses guarantee the
fulfillment of futures contract obligations by all
parties involved.
June 30, 2012

AN EXAMPLE:
90-DAY EURODOLLAR TIME
DEPOSIT FUTURES
Eurodollar

futures contracts are traded on the

International Monetary Market (IMM), a division
of the Chicago Mercantile Exchange.
The underlying asset is a Eurodollar time deposit
with a 3-month maturity.

Eurodollar rates are quoted on an interest-bearing

basis, assuming a 360-day year.
Each Eurodollar futures contract represents $1 million
of initial face value of Eurodollar deposits maturing
three months after contract expiration.
Forty separate contracts are traded at any point in time,
as contracts expire in March, June, September and
December

June 30, 2012

AN EXAMPLE:
90-DAY EURODOLLAR TIME DEPOSIT
FUTURES
Eurodollar futures contracts trade
according to an index that equals 100
percent minus the futures interest rate
expressed in percentage terms.

An index of 91.50 indicates a futures rate of 8.5

percent.
Each basis point change in the futures rate
equals a $25 change in value of the contract
(0.0001 x $1 million x 90/360).

June 30, 2012

EURODOLLAR
FUTURES

The first column indicates the

settlement month and year.
Each row lists price and yield
data for a distinct futures
contract that expires
sequentially every three
months.
The next four columns report
the opening price, high and low
price, and closing settlement
price.
The next column, headed Chg,
states the change in settlement
price from the previous day.
The two columns under Yield
convert the settlement price to
a Eurodollar futures rate as:
100 - settlement price = futures
rate
June 30, 2012

3 -M O . E U R O D O L L A R (C M E )-$ 1 M IL L IO N ; P T S O F 1 0 0 %
Y ie ld
O pen
O p e n H i g h L o w S e t t l e C h g S e tt l e C h g I n t e r e s t
J u ly
9 4 .3 0 9 4 .3 1 9 4 .3 0 9 4 .3 1 ..... 5 .6 9
..... 3 1 ,1 8 2
A ug
9 4 .3 1 9 4 .3 1 9 4 .3 1 9 4 .3 1 ..... 5 .6 9
.....
9 ,3 8 0
S ept
9 4 .3 1 9 4 .3 1 9 4 .3 0 9 4 .3 1 ..... 5 .6 9
..... 5 1 0 ,6 0 6
O ct
.....
.....
..... 9 4 .2 7 ..... 5 .7 3
.....
2 ,1 9 2
N ov
.....
.....
..... 9 4 .2 7 ..... 5 .7 3
.....
672
D ec
9 4 .2 6 9 4 .2 7 9 4 .2 4 9 4 .2 6 ..... 5 .7 4
..... 3 8 7 ,5 3 1
M r9 9 9 4 .3 1 9 4 .3 1 9 4 .2 8 9 4 .3 1 ..... 5 .6 9
..... 3 2 5 .3 4 2
June
9 4 .3 0 9 4 .3 0 9 4 .2 8 9 4 .2 8 ..... 5 .7 2
..... 2 6 9 ,6 4 1
S ept
9 4 .2 6 9 4 .2 7 9 4 .2 6 9 4 .2 6 ..... 5 .7 4
..... 2 2 9 ,0 7 5
D ec
9 4 .1 7 9 4 .1 7 9 4 .1 5 9 4 .1 6 ..... 5 .8 4
..... 1 9 0 ,8 3 2
M r0 0 9 4 .2 1 9 4 .2 1 9 4 .2 0 9 4 .2 1 ..... 5 .7 9
..... 1 5 9 ,1 3 9
June
9 4 .1 8 9 4 .1 8 9 4 .1 7 9 4 .1 8 ..... 5 .8 2
..... 1 4 3 ,0 0 7
S ept
9 4 .1 7 9 4 .1 7 9 4 .1 5 9 4 .1 6 ..... 5 .8 4
..... 8 7 ,2 5 1
D ec
9 4 .0 9 9 4 .0 9 9 4 .0 8 9 4 .0 9 ..... 5 .9 1
..... 7 3 ,2 0 5
M r0 1 9 4 .1 2 9 4 .1 3 9 4 .1 2 9 4 .1 2 ..... 5 .8 8
..... 6 7 ,2 2 2
June
9 4 .1 1 9 4 .1 1 9 4 .1 0 9 4 .1 1 ..... 5 .8 9
..... 5 8 ,3 4 1
S ept
9 4 .1 0 9 4 .1 0 9 4 .0 9 9 4 .1 0 ..... 5 .9 0
..... 4 7 ,3 6 2
D ec
9 4 .0 3 9 4 .0 4 9 4 .0 2 9 4 .0 3 ..... 5 .9 7
..... 4 1 ,4 1 5
M r0 2 9 4 .0 7 9 4 .0 7 9 4 .0 6 9 4 .0 7 ..... 5 .9 3
..... 4 6 ,0 1 2
June
9 4 .0 5 9 4 .0 6 9 4 .0 4 9 4 .0 5 ..... 5 .9 5
..... 4 5 ,8 1 5
S ept
9 4 .0 4 9 4 .0 5 9 4 .0 4 9 4 .0 4 ..... 5 .9 6
..... 4 3 ,1 8 4
D ec
9 3 .9 7 9 3 .9 8 9 3 .9 6 9 3 .9 7 ..... 6 .0 3
..... 3 2 ,7 3 6
M r0 3 9 4 .0 1 9 4 .0 1 9 4 .0 0 9 4 .0 1 ..... 5 .9 9
..... 2 8 ,8 1 2
June
9 3 .9 9 9 3 .9 9 9 3 .9 8 9 3 .9 9 ..... 6 .0 1
..... 2 0 ,3 7 3
S ept
9 3 .9 8 9 3 .9 8 9 3 .9 8 9 3 .9 8 ..... 6 .0 2
..... 1 5 ,8 6 4
D ec
9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .9 1 ..... 6 .0 9
.....
8 ,7 4 4
M r0 4 9 3 .9 4 9 3 .9 4 9 3 .9 4 9 3 .9 4 ..... 6 .0 6
.....
7 ,5 0 5
June
.....
.....
..... 9 3 .9 1 ..... 6 .0 9
.....
8 ,5 5 3
S ept
9 3 .9 1 9 3 .9 1 9 3 .9 1 9 3 .8 9 ..... 6 .1 1
.....
6 ,9 3 8
D ec
.....
.....
..... 9 3 .8 2 ..... 6 .1 8
.....
7 ,3 9 7
M r0 5
.....
.....
..... 9 3 .8 5 ..... 6 .1 5
.....
5 ,5 7 6
June
.....
.....
..... 9 3 .8 3 ..... 6 .1 7
.....
5 ,3 2 3
S ept
.....
.....
..... 9 3 .8 1 ..... 6 .1 9
.....
4 ,2 5 0
D ec
.....
.....
..... 9 3 .7 4 ..... 6 .2 6
.....
3 ,7 3 5
M r0 6
.....
.....
..... 9 3 .7 7 ..... 6 .2 3
.....
5 ,8 1 6
June
.....
.....
..... 9 3 .7 4 ..... 6 .2 6
.....
3 ,6 4 8
S ept
.....
.....
..... 9 3 .7 2 ..... 6 .2 8
.....
4 ,7 0 9
D ec
.....
.....
..... 9 3 .6 5 ..... 6 .3 5
.....
5 ,3 3 1
M r0 7
.....
.....
..... 9 3 .6 8 ..... 6 .3 2
.....
4 ,0 7 5
June
9 3 .6 9 9 3 .6 9 9 3 .6 9 9 3 .6 6 1 .0 1 6 .3 4 2 .0 1
4 ,2 0 5
S ept
.....
.....
..... 9 3 .6 4 1 .0 1 6 .3 6 2 .0 1
4 ,6 1 9
D ec
.....
.....
..... 9 3 .5 7 1 .0 1 6 .4 3 2 .0 1
3 ,6 8 0
M r0 8
.....
.....
..... 9 3 .6 0 1 .0 1 6 .4 0 2 .0 1
3 ,4 0 6
June
.....
.....
..... 9 3 .5 7 1 .0 1 6 .4 3 2 .0 1
295
E s t v o l 1 3 6 , 1 8 2 ; v o l F r i 2 2 7 , 5 8 8 ; o p e n i n t 2 , 9 6 31 ,19 19 , 66 ,4 5 .

SPECULATING WITH
FUTURES, LONG

Buying a futures contract (today) is often referred to

as going long, or establishing a long position.

Recall: Each futures contract has an expiration date.

Every day before expiration, a new futures price is established.

If this new price is higher than the previous days price, the
holder of a long futures contract position profits from this
futures price increase.

If this new price is lower than the previous days price, the
holder of a long futures contract position loses from this
futures price decrease.

June 30, 2012

EXAMPLE I: SPECULATING
IN GOLD FUTURES

You believe the price of gold will go up. So,

You go long 100 futures contract that expires in 3 months.

The futures price today is $400 per ounce.
There are 100 ounces of gold in each futures contract.

Your "position value" is: $400 X 100 X 100 = $4,000,000

Suppose your belief is correct, and the price of gold is $420

when the futures contract expires.

Your "position value" is now: $420 X 100 X 100 = $4,200,000

Your "long" speculation has resulted in a gain of $200,000

What would have happened if the gold price was $370?
June 30, 2012

SPECULATING WITH
FUTURES, SHORT
Selling

a futures contract (today) is often called

going short, or establishing a short position.

Recall:

date.

Each futures contract has an expiration

Every day before expiration, a new futures price is

established.

If this new price is higher than the previous days price,

the holder of a short futures contract position loses from
this futures price increase.

If this new price is lower than the previous days price,

the holder of a short futures contract position profits
from this futures price decrease.
June 30, 2012

EXAMPLE II:
SPECULATING IN GOLD
You believe the price of gold will go down. So,
FUTURES

You go short 100 futures contract that expires in 3 months.

The futures price today is $400 per ounce.
There are 100 ounces of gold in each futures contract.

Your "position value" is: $400 X 100 X 100 = $4,000,000

Suppose your belief is correct, and the price of gold is $370

when the futures contract expires.

Your position value is now: $370 X 100 X 100 = $3,700,000

Your "short" speculation has resulted in a gain of $300,000

What would have happened if the gold price was $420?
June 30, 2012

INTEREST RATE SWAPS

June 30, 2012Juliet Delos Santos

Swaps Contracts
In

a swap, two counterparties agree to a

contractual arrangement wherein they
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 just called

interest rate swaps.

Cross-Currency interest rate swap

This is often called a currency swap; fixed for fixed rate debt
service in two (or more) currencies.

June 30, 2012

Swap Bank
A

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.

June 30, 2012

Example: Interest Rate

Swap

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
$10,000,000 to finance floating-rate
Eurodollar loans.

Bank A is considering issuing 5-year fixed-rate Eurodollar

bonds at 10 percent.
It would make more sense to for the bank to issue
floating-rate notes at LIBOR (London Interbank
Offered Rate) to finance floating-rate Eurodollar loans.

June 30, 2012

Example: Interest Rate

Swap (cont.)

Firm

B is a BBB-rated U.S.
company. It needs $10,000,000 to
finance an investment with a fiveyear economic life.

Firm B is considering issuing 5-year fixed-rate

Eurodollar bonds at 11.75 percent.
Alternatively, firm B can raise the money by issuing
5-year floating-rate notes at LIBOR + percent.
Firm B would prefer to borrow at a fixed rate.

June 30, 2012

Example: Interest Rate

Swap (cont.)

The borrowing opportunities of the

two firms are:

June 30, 2012

Example: Interest Rate

Swap (cont.)
The swap bank
makes this offer to
Bank A: You pay
LIBOR 1/8 % per
year on $10M for 5
yrs. and we will pay
you 10 3/8% on $10M
for 5 yrs.

Swap
10 3/8%

Bank

LIBOR 1/8%

Bank
A
COMPANY
Fixed rate
Floating rate

June 30, 2012

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Example: Interest Rate

Swap (cont.)
% of $10M =
$50K. Thats
quite a cost
savings per yr. 10 3/8%
for 5 yrs.

Swap
Bank

LIBOR 1/8%

Bank
10
%

-10 3/8 + 10 +
(LIBOR 1/8) =

COMPANY
Floating rate

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Fixed rate

June 30, 2012

Heres whats in
it for Bank A: They
can borrow
externally at 10%
fixed and have a
net borrowing
position of

LIBOR % which
is % better than
they can borrow

Example: Interest Rate

Swap (cont.)
The swap
bank makes
this offer to
company B:
You pay us
10% per year
on $10 million
for 5 years and
we will pay you
LIBOR %
per year on
$10 million for
June 30, 2012
5 years.

Swap
Bank

10 %

LIBOR %

Compan
y
B
COMPANY
Fixed rate
Floating rate

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

Example: Interest Rate

Swap (cont.)

Heres whats
in it for B:

They can borrow

externally at
LIBOR + % and
have a net
borrowing position
of 10 + (LIBOR +
) - (LIBOR - ) =
11.25% which is
% better than they
can June
borrow
floating.
30, 2012

Swap
Bank

% of $10M =
$50K thats quite
a cost savings per
yr. for 5 yrs.

10
%
LIBOR %

Compan
y
B
COMPANY
Fixed rate
Floating rate

LIBO
R+
%

BANK A

11.75%

10%

LIBOR + .5%

LIBOR

25-51

Example: Interest Rate

Swap (cont.)

The swap bank makes money

too.
Swap
10 3/8%

% of $10M=
$25,000 per
yr. for 5 yrs.

Bank

10 %

LIBOR 1/8% LIBOR %

Bank
A

LIBOR 1/8 [LIBOR ]=

1/8

Compan
y

10 - 10 3/8 = 1/8
COMPANY
Fixed rate
Floating rate
June 30, 2012

11.75%
LIBOR + .5%

A
BANK
10%
LIBOR
25-52

Example: Interest Rate

Swap (cont.)
The swap bank makes
%
Swap

10 3/8%

Bank

10 %

LIBOR 1/8% LIBOR %

Bank
A
A saves
%
Fixed rate
Floating rate
June 30, 2012

Compan
y

COMPANY

11.75%
LIBOR + .5%

B
B saves
%

BANK A
10%

LIBOR
25-53

Example: Currency Swap

Suppose

a U.S. MNC wants to finance a 10M

expansion of a British plant.
They could borrow dollars in the U.S. where
they are well known and exchange for dollars
for pounds.

This will give them exchange rate risk: financing a

sterling project with dollars.

They

could borrow pounds in the international

bond market, but pay a premium since they
are not as well known abroad.
June 30, 2012

Example: Currency Swap

(cont.)

If

they can find a British MNC with a

mirror-image financing need they may
both benefit from a swap.
If the spot exchange rate is S0($/) =
$1.60/, the U.S. firm needs to find a
British firm wanting to finance dollar
borrowing in the amount of $16M.

June 30, 2012

Example: Currency Swap

(cont.)

Consider

two firms A and B: firm A is a

U.S.based multinational and firm B is a
U.K.based multinational.
Both firms wish to finance a project in each
others country of the same size. Their
borrowing opportunities are given in the
table below.
$

Company A

8.0%

11.6%

Company B

10.0%

12.0%

June 30, 2012

Example: Currency Swap

(cont.)
As net position is to borrow
at 11%
Swap
$8%

Bank

11%
$8%

12
%

Firm
A

June 30, 2012

$9.4
%

A savaes .6%
$

Company A

8.0%

11.6%

Company B

10.0% 12.0%

Firm
B

12
%

Example: Currency Swap

(cont.)

Bs net position is to borrow at

$9.4%
Swap
$8%

Bank

$9.4
%

11%
$8%

12
%

Firm
A
$

Company A

8.0%

11.6%

Company B

10.0% 12.0%

June 30, 2012

Firm
B

12
%

B saves $.6%

Example: Currency Swap

(cont.)
The swap bank makes
money too:

Swap
$8%
11%

$8%

Firm

Bank

1.4% of $16
million
financed with
1% of 10
$9.4
million per
%
year for 5
12
Firm years.
12
%
%
is a
B

At S0($/) =
$1.60/, that
A
gain of $64,000
per year $for 5
years.
Company
A 8.0% 11.6%
Company B

June 30, 2012

10.0% 12.0%

The swap bank

faces exchange
rate risk, but
maybe they can
lay it off (in

Variations of Basic Swaps

Currency

fixed for fixed

fixed for floating
floating for floating
amortizing

Interest

Swaps

Rate Swaps

zero-for floating
floating for floating

Exotica

For a swap to be possible, two humans must like the idea. Beyond
that, creativity is the only limit.
June 30, 2012

Risks of Interest Rate and Currency

Swaps
Interest

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

Rate Risk

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 pound
appreciated.
June 30, 2012

25-61

Risks of Interest Rate and Currency

Swaps
Credit

Risk

This is the major risk faced by a swap dealerthe risk

that a counter party will default on its end of the swap.

Mismatch

Its hard to find a counterparty that wants to borrow

the right amount of money for the right amount of
time.

Sovereign

Risk

Risk

The risk that a country will impose exchange rate

restrictions that will interfere with performance on the
swap.
June 30, 2012

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.

June 30, 2012

Derivatives Prevailing in the

Philippine Market
Forward
Swap (Interest or Asset)
Options
Credit-Linked Notes
Structured Product Structured Yield
Deposit

Source: BSP Circular 594

June 30, 2012

What is corporate risk

management, and why is it
important
all firms?
Corporate riskto
management
relates to the

management of unpredictable events that

would have adverse consequences for the firm.
All firms face risks, but the lower those risks
can be made, the more valuable the firm,
other things held constant. Of course, risk
reduction has a cost.

June 30, 2012

Definitions of different
types of risk

Speculative risks offer the chance of a gain

as well as a loss.

Pure risks offer only the prospect of a loss.

Demand risks risks associated with the

demand for a firms products or services.

Input risks risks associated with a firms

input costs.
Financial risks result from financial
transactions.

June 30, 2012

Definitions of different
types of risk

Property risks risks associated with loss of

a firms productive assets.
Personnel risk result from human actions.
Environmental risk risk associated with
polluting the environment.
Liability risks connected with product,
service, or employee liability.
Insurable risks risks that typically can be
covered by insurance.

June 30, 2012

What are the three steps of

corporate risk
1. Identify the risks faced by the firm.
management?
2.
3.

Measure the potential impact of the

identified risks.
Decide how each relevant risk should
be handled.

June 30, 2012

What can companies do to

minimize or reduce risk
exposure?

Transfer risk to an insurance company by paying

periodic premiums.
Transfer functions that produce risk to third
parties.
Purchase derivative contracts to reduce input and
financial risks.
Take actions to reduce the probability of
occurrence of adverse events and the magnitude
associated with such adverse events.

Avoid the activities that give rise to risk.

June 30, 2012

Leasing and Other

Asset-Based
Financing
Corporate Financial Management 3e
Emery Finnerty Stowe
Modified for course use by Arnold R. Cowan

June 30, 2012

Lease Financing

A lease is a rental agreement that extends for

one year or longer.
The owner of the asset (the lessor) grants
exclusive use of the asset to the lessee for a fixed
period of time.

In return, the lessee makes fixed periodic payments to

the lessor.

At termination, the lessee may have the option to

either renew the lease or purchase the asset.

June 30, 2012

71

Types of Leases

Full-service lease

Lessor responsible for maintenance, insurance,

and property taxes.

Net lease

Lessee responsible for maintenance, insurance,

and property taxes.

June 30, 2012

72

Types of Leases

Operating lease

short-term
may be cancelable

Financial lease

long-term
similar to a loan agreement

June 30, 2012

73

Types of Lease Financing

Direct leases
Sale-and-lease-back agreements
Leveraged leases

June 30, 2012

74

Direct Lease
Lessee

Manufacturer
/ Lessor

Lease

or

Lessee
June 30, 2012

Lease

Lessor

Sale of Asset

Manufacturer
/ Lessor
75

Sale-and-Lease-Back

Lessee

June 30, 2012

Sale of Asset

Lessor

Lease

76

Leveraged Lease
Manufacturer
Sale of Asset

Lessee
June 30, 2012

Lease

Single
Purpose
Leasing
Company

Lien

Lender

Loan

Equity

Equity
Investor
77

Synthetic Leases
Firms have used synthetic leases to get
the use of assets but keep debt off their
balance sheets.
An unrelated financial institution invests
some equity and sets up a specialpurpose-entity that buys the assets and
leases it to the firm under an operating
lease.
Since the Enron bankruptcy, firms have
been reluctant to use synthetic leases.

June 30, 2012

78

Advantages of Leases

Efficient use of tax deductions and tax credits of

ownership
Reduced risk
Reduced cost of borrowing
Bankruptcy considerations
Tapping new sources of funds
Circumventing restrictions

debt covenants
off-balance sheet financing

June 30, 2012

79

Disadvantages of Leasing

Lessee forfeits tax deductions associated

with asset ownership.
Lessee usually forgoes residual asset
value.

June 30, 2012

80

Valuing Financial Leases

Basic approach is similar to debt refunding.

Lease displaces debt.
Missed lease payments can result in the lessor

claiming the asset.

filing lawsuits.
forcing firm into bankruptcy.

Risk of a firms lease payments are similar to

those of its interest and principal payments.

June 30, 2012

81

Project Financing

Desirable when

Project can stand alone as an economic unit.

Project will generate enough revenue (net of
operating costs) to service project debt.

Examples:

Mines & mineral processing facilities

Pipelines
Oil refineries
Paper mills
June 30, 2012

82

Project Financing
Arrangements

Completion undertaking
Purchase, throughput, or tolling
agreements
Cash deficiency agreements

June 30, 2012

83

Advantages and
Disadvantages of Project
Financing
Advantages

Risk sharing
Expanded debt capacity
Lower cost of debt

Disadvantages

Significant transaction costs and legal fees

Complex contractual agreements
Lenders require a higher yield premium

June 30, 2012

84

Limited Partnership
Financing
Another form of tax-oriented financing.
Allows the firm to sell the tax
deductions and credits associated with
asset ownership to the limited partners.
Income (or loss) for tax purposes flows
through to the partners.
Limited partners are passive investors.
General partner operates the limited
partnership and has unlimited liability.

June 30, 2012

85

June 30, 2012

8
7

Leveraged Buyouts
(LBO)

LBOs are a way to take a public company private, or put a

company in the hands of the current management, MBO.
LBOs are financed with large amounts of borrowing
(leverage), hence its name.
LBOs use the assets or cash flows of the company to
secure debt financing, bonds or bank loans, to purchase
the outstanding equity of the company.
After the buyout, control of the company is concentrated in
the hands of the LBO firm and management, and there is
no public stock outstanding.

8
8

History: LBO

Leveraged buyouts were a relatively obscure

means of financing large corporate acquisitions
in the post WWII period. The practice positively
boomed in the 1980s, with a combined $188
billion in acquisitions taking place in 1988 alone.
The term hostile takeover coined during this
period, it reflects the mixed feelings towards
LBO.

8
9

Successful LBO
Finding cheap
assets buying low
Strategies

and selling high (value arbitrage or

multiple expansion)

Unlocking value through

restructuring:

Financial restructuring of balance sheet

improved combination of debt and
equity

Key Terms and concepts regarding

Transaction fee amortization. This reflects the capitalization
and amortization of financing, legal, and accounting fees
associated with the transaction.
- its like depreciation, is a tax-deductible noncash
expense.

Interest Expense- For simplicity, interest expense for each

tranche of debt financing is calculated based on the yearly
beginning balance of each tranche.

Capitalization. Most leveraged buyouts make use of multiple

tranches of debt to finance the transaction. A simple
transaction may have only two tranches of debt, senior and
junior. A large leveraged buyout will likely be financed with
multiple tranches of debt that could include some or all of the
following:

Revolving credit facility (revolver). This is a source of

Bank debt. Often secured by the assets of the

bought-ought firm, this is the most senior claim
against the cash flows of the business.

Mezzanine Debt exists in the middle of the

capital structure and is junior to the bank debt
incurred in financing the leveraged buyout.

Subordinated or high yield notes (junk

bonds) most junior source of debt financing
and as such has the highest interest rates.

Cash Sweep - is a provision of certain debt

covenants that stipulates that any excess cash
generated by the bought out business will be
used to pay down principal.

Exit Scenario usually involves either a sale

of portfolio company or recapitalization.