Graduate School of Business and Law

``

BUSM4160 Managerial Finance

Topic 11: Derivatives and Hedging Risk
 Key Concepts and Skills

Understand the basics of forward and

futures contracts

Understand how derivatives can be used to

hedge risks faced by the corporation

RMIT University6/1/17 2
 Topic Outline

Derivatives, Hedging, and Risk

Forward Contracts
Futures Contracts
Hedging
Interest Rate Futures Contracts
Duration Hedging
Swap Contracts
Actual Use of Derivatives

RMIT University6/1/17 3 3
 What is a derivative?
A derivative is a financial instrument whose
payoffs and values are derived from, or depend
on, something else:
Examples:
Forward agreement
Futures
Swaps
Options

RMIT University6/1/17 4
 Forward Contracts

A forward contract specifies that a certain

commodity will be exchanged at a specified
time in the future at a price specified today.
Its not an option: both parties are expected 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.

RMIT University6/1/17 5 5
 Futures Contracts

A futures contract is likea forward contract:

It specifies that a certain commodity will be
exchanged at a specified time in the future at a
price specified today.
A futures contract is different froma forward:
Futures are standardized contracts trading on
organized exchanges with daily resettlement
(marking to market) through a clearinghouse.

RMIT University6/1/17 6 6
 Futures Contracts some Language

Going short
delivering the commodity / currency

Going long
receiving the commodity / currency

RMIT University6/1/17 7
 Futures Contracts

Standardizing Features
Contract Size
Delivery Month
Daily resettlement
Minimizes the chance of default
Initial Margin
About 4-10%of contract value
Cash or T-bills held in a street name at your
brokerage

RMIT University6/1/17 8 8
 Daily Resettlement: An Example

RMIT University6/1/17 9
 Daily Resettlement: An Example

RMIT University6/1/17 10 10
 Daily Resettlement: An Example

RMIT University6/1/17 11 11
 Daily Resettlement: An Example

The $559.29 comes out of your $3,333.33

margin account, leaving $2,774.04.
This is short of the $3,355.70 required for a
new position.
$1
$3,355.70 = 0.04 12,500,000
149
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.

RMIT University6/1/17 12 12
 Selected Futures Contracts

RMIT University6/1/17 13 13
 Basic Futures Relationships

Open Interest refers to the number of

contracts outstanding for a particular delivery
month.
Open interest is a good proxy for the 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) are outstanding.

RMIT University6/1/17 14 14
 What is hedging?
Making an investment to reduce the risk of
adverse price movements in an asset.
When a firm uses derivatives to reduce its risk
exposure, it is hedging:
e.g. an orchard business enters into a futures
contract for its citrus crop
e.g. an importer of machinery from Germany
uses a forward rate agreement for the Euro and
the Australian dollar

RMIT University6/1/17 15
 Hedging vs. Speculation
Hedging involves taking an offsetting position in a
derivative in order to balance any gains and
losses to the underlying asset
e.g. an importer arranging a forward rate
agreement for the currency of payment.
The main purpose of speculation is to profit from
betting in the direction in which an asset will be
moving.
e.g. a firm with no exposure to a particular
currency taking out a forward rate agreement

RMIT University6/1/17 16
 Hedging

Two counterparties with offsetting risks can

eliminate risk.
For example, if a wheat farmer and a flour mill 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, who absorb price risk from hedgers.
Speculating: Long vs. Short

RMIT University6/1/17 17 17
 Hedging some Language

short hedge
a transaction that secures protection
against a possible decline in price of an
item to be traded at a later time
long hedge
a transaction that secures protection
against a possible increase in price of an
item to be traded at a later time

RMIT University6/1/17 18
 Hedging and Speculating: Example

You speculate that copper will go up in price, so you go

long 10 copper contracts for delivery in 3 months. A
contract is 25,000 pounds in cents per pound and is
at $0.70 per pound, or $17,500 per contract.

If futures prices rise by 5 cents, you will gain:

Gain =25,000 .05 10 =$12,500

If prices decrease by 5 cents, your loss is:

Loss =25,000 ( .05) 10 =$12,500

RMIT University6/1/17 19
 Hedging: How many contracts?

RMIT University6/1/17 20 20
 Interest Rate Futures Contracts

Pricing of Treasury Bonds

Pricing of Forward Contracts
Futures Contracts
Hedging in Interest Rate Futures

RMIT University6/1/17 21 21
 Pricing of Treasury Bonds

RMIT University6/1/17 22 22
 Pricing of Treasury Bonds

RMIT University6/1/17 23
 Pricing of Forward Contracts

RMIT University6/1/17 24
 Pricing of Futures Contracts

The pricing equation given above will be a

good approximation.
The only real difference is the daily
resettlement.

RMIT University6/1/17 25
 Hedging in Interest Rate Futures

A mortgage lender who has agreed to loan

money in the future at prices set today can
hedge by selling those mortgages forward.
It may be difficult to find a counterparty in the
forward who wants the precise mix of risk,
maturity, and size.
It is likely to be easier and cheaper to use
interest rate futures contracts.

RMIT University6/1/17 26
 Duration Hedging

RMIT University6/1/17 27
 Duration Hedging

Duration measures the combined effect of

maturity, coupon rate, and YTM on a bonds
price sensitivity to interest rates.
Measure of the bonds effective maturity
Measure of the average life of the security
Weighted average maturity of the bonds cash
flows

RMIT University6/1/17 28
 Duration Formula

RMIT University6/1/17 29
 Calculating Duration: Example

Calculate the duration of a three-year bond

that pays a semiannual coupon of $40 and
has a $1,000 par value when the YTM is 8%.

RMIT University6/1/17 30
 Calculating Duration: Example

RMIT University6/1/17 31
 Duration

RMIT University6/1/17 32
 Swaps Contracts

In a swap, two counterpartiesconsent 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.

RMIT University6/1/17 33
 The 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.

RMIT University6/1/17 34
 An Example of an Interest Rate Swap

RMIT University6/1/17 35
 An Example of an Interest Rate Swap

Firm B is a BBB-rated U.S. company. It needs

$10,000,000 to finance an investment with a
five-year 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.

RMIT University6/1/17 36
 An Example of an Interest Rate Swap

RMIT University6/1/17 37
 An Example of an Interest Rate Swap

RMIT University6/1/17 38
 An Example of an Interest Rate Swap

RMIT University6/1/17 39
 An Example of an Interest Rate Swap

RMIT University6/1/17 40
 An Example of an Interest Rate Swap

RMIT University6/1/17 41
 An Example of an Interest Rate Swap

RMIT University6/1/17 42
 An Example of an Interest Rate Swap

RMIT University6/1/17 43
 An Example of a Currency Swap

Suppose a U.S. MNCwants to finance a

10,000,000 expansion of a British plant.
They could borrow dollars in the U.S. where
they are well known and exchange 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.

RMIT University6/1/17 44
 An Example of a Currency Swap

If they can find a British MNCwith 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 $16,000,000.

RMIT University6/1/17 45
 An Example of a Currency Swap

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.

RMIT University6/1/17 46
 An Example of a Currency Swap

RMIT University6/1/17 47
 An Example of a Currency Swap

RMIT University6/1/17 48
 An Example of a Currency Swap

RMIT University6/1/17 49
 An Example of a Currency Swap

RMIT University6/1/17 50
 Credit Default Swaps

Counterparty #1 (protection buyer) makes a

periodic payment (CDS spread) to
counterparty #2 (protection seller).
In exchange, counterparty #2 agrees to pay for
a particular bond issue should a default occur.
Historically, these contracts were traded on a
customized basis. The lack of an exchange
creates counterparty risk.

RMIT University6/1/17 51
 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.

RMIT University6/1/17 52
 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 pound
appreciated.

RMIT University6/1/17 53
 Risks of Interest Rate and Currency Swaps

Credit Risk
This is the major risk faced by a swap dealerthe risk
that a counterparty will default on its end of the swap.
Mismatch Risk
It is hard to find a counterparty that wants to borrow
the right amount of money for the right amount of
time.
Sovereign Risk
The risk that a country will impose exchange rate
restrictions that will interfere with performance on the
swap.

RMIT University6/1/17 54
 Pricing a Swap

A swap is a derivative security, so it can be

priced in terms of the underlying assets:
Plain vanilla fixed for floating swap gets valued
just like a bond.
Currency swap gets valued just like a nest of
currency futures.

RMIT University6/1/17 55
 Actual Use of Derivatives

Because derivatives do not appear on the

balance sheet, they present a challenge to
financial economists who wish to observe
their use.
Survey results appear to support the notion of
widespread use of derivatives among large
publicly traded firms.
Foreign currency and interest rate derivatives
are the most frequently used.

RMIT University6/1/17 56
End of Topic 11

57