HEDGING

Submitted To: Sir Ismial Sb Submitted By: Mehboob Ahmad (MBED-10-13) Javeria Jaan (MBED-10-04) Aiman Fatima (MBED-10-05) Sehrish Khan (MBED-10-06)

MEHBOOB AHMED

AN INTRODUCTION TO SWAPS

A swap is an agreement between counter-parties to exchange cash flows at specified future times according to pre-specified conditions.

A swap is equivalent to a coupon-bearing asset plus a coupon-bearing liability. The coupons might be fixed or floating. A swap is equivalent to a portfolio, or strip, of forward contracts--each with a different maturity date, and each with the same forward price.

David

A PLAIN VANILLA INTEREST RATE SWAP, I.

Party B agrees to pay a fixed payment and receive a floating payment, from counter-party A. Party B is the fixed rate payer-floating rate receiver (the pay-fixed party). Party A is the fixed rate receiver-floating rate payer (the receive-fixed party). Typically, there is no initial exchange of principal (i.e., no cash flow at the initiation of the swap).

David

THE CASH FLOWS TO COMPANY B

---------Millions of Dollars---------

LIBOR FLOATING
Date Rate

FIXED

Net

Cash Flow Cash Flow Cash Flow +2.10 +2.30 2.50 2.50 0.40 0.20

Mar.1, 2002
Sept. 1, 2002 Mar.1, 2003

4.2%
4.6% 5.1%

Sept. 1, 2003
Mar.1, 2004

5.5%
5.6%

+2.55
+2.75

2.50
2.50

+0.05
+0.25

Sept. 1, 2004
Mar.1, 2005

4.9%
4.4%

+2.80
+2.45

2.50
2.50

+0.30
- 0.05

David Dubofsky and 11- 5 Thomas W. Miller, Jr.

A CLOSER LOOK AT THE CASH FLOWS ON SEPTEMBER 1, 2002

Floating Payment:

Based on the 6-month LIBOR rate that existed on March 1, 2002: 4.20%. ($100,000,000)(0.042)(1/2) = +$2,100,000.

Fixed Payment:

Based on 5% rate. ($100,000,000)(0.05)(1/2) = -$2,500,000.

Net Cash Flow: -$400,000.

David Dubofsky and 11- 6 Thomas W. Miller, Jr.

TYPICAL USES OF AN INTEREST RATE SWAP

To convert a liability from: a fixed rate to floating rate. a floating rate to fixed rate. To convert an investment (asset) from: a fixed rate to floating rate. a floating rate to fixed rate.

David Dubofsky and 11- 7 Thomas W. Miller, Jr.

CURRENCY SWAPS

There are four types of basic currency swaps:

fixed for fixed. fixed for floating. floating for fixed. floating for floating.

N.B.: It is the interest rates that are fixed or floating.

Typically, the NP is exchanged at the swaps initiation and termination dates.

David Dubofsky and 11- 8 Thomas W. Miller, Jr.

TYPICAL USES OF A CURRENCY SWAP

To convert a liability in one currency into a liability in another currency. To convert an investment (asset) in one currency to an investment in another currency.

David Dubofsky and 11- 9 Thomas W. Miller, Jr.

AN EXAMPLE OF A FIXED FOR FIXED CURRENCY SWAP

An agreement to pay 1% on a Japanese Yen principal of 1,040,000,000 and receive 5% on a US dollar principal of $10,000,000 every year for 3 years. In a currency swap, unlike in an interest rate swap, the principal is exchanged at the beginning and at the end of the swap. Note that in currency swaps, the direction of the cash flows at time zero is the opposite of the direction of the subsequent cash flows in the swap (see the next slide).

David Dubofsky and 11- 10 Thomas W. Miller, Jr.

CASH FLOWS IN A FIXED-FOR-FIXED CURRENCY SWAP

At origination:
$10,000,000

Party A
1,040,000,000

Party B

At each annual settlement date:

Party A $500,000 10,400,000 Party B

At maturity:
Party A

$10,000,000 Party B 1,040,000,000

David Dubofsky and 11- 11 Thomas W. Miller, Jr.

CASH FLOWS IN A FIXED-FOR-FLOATING CURRENCY SWAP

On the origination date:

The fixed rate payer pays $10,000,000 to the fixed rate receiver. The fixed rate receiver pays 1,040,000,000 to the fixed rate payer.

Fixed rate payer (Floating rate Receiver)

$10,000,000 Fixed rate Receiver (Floating Rate Payer) 1,040,000,000

David Dubofsky and 11- 12 Thomas W. Miller, Jr.

CALCULATING SUBSEQUENT CASH FLOWS FOR THIS FIXED-FOR-FLOATING CURRENCY SWAP Tenor is three years. NP1 = 1,040,000,000 yen, and r1 = 1% fixed in

yen. NP2 = $10,000,000, and r2 = 6 month $-LIBOR (floating). Settlement dates are every 6 months, beginning 6 months hence. On the origination date, 6 month LIBOR is 5.5%. Assume that subsequently, 6 mo. LIBOR is:
Time 0.5 1.0 1.5 2.0 2.5 6 mo. LIBOR 5.25% 5.50% 6.00% 6.20% 6.44%

David Dubofsky and 11- 13 Thomas W. Miller, Jr.

ALL CASH FLOWS FOR THIS FIXED-FORFLOATING CURRENCY SWAP

6-mo. time 0.0 0.5 1.0 1.5 2.0 2.5 3.0 Fixed rate LIBOR Payment 5.50% $10MM 5.25% 5.2MM 5.50% 5.2MM 6.00% 5.2MM 6.20% 5.2MM 6.44% 5.2MM ---5.2MM 1,040MM Floating rate Payment 1,040MM $275,000 $262,5001 $275,000 $300,000 $310,000 $322,000 $10MM

N.B. The time t floating cash flow is determined using the time t-1 floating rate. 1 Time 1.0 floating rate payment is (0.0525/2)($10,000,000) = $262,500.

David Dubofsky and 11- 14 Thomas W. Miller, Jr.

CREDIT RISK: CURRENCY SWAPS

Note that there is greater credit risk with a currency swap when there will be a final exchange of principal. This means that there is a higher probability of a large buildup in value, giving one of the counter-parties (the one who is losing) the incentive to default.
David Dubofsky and 11- 15 Thomas W. Miller, Jr.

CREDIT RISK

No credit risk exists when a swap is first created. The credit risk in a swap is greater when there is an exchange of principal amounts at termination. Only the winning party (for whom the swap is an asset) faces credit risk. This risk is the risk that the counter-party will default. Many vehicles exist to manage credit risk:

Collateral (or collateral triggers) Netting agreements Credit derivatives Marking to market
David Dubofsky and 11- 16 Thomas W. Miller, Jr.

COMMODITY SWAPS

For example, consider a commodity swap involving a notional principal of 1,00,000 barrels of crude oil. One party agrees to... make fixed semi-annual payments at a fixed price of Rs 2,500/bbl, and receive floating payments. On the first settlement date, if the spot price of crude oil is Rs 2,400/bbl, the pay-fixed party must pay (Rs 2,500/bbl)*(1, 00,000 bbl) = Rs 2,50,000,000. The pay-fixed party also receives (Rs 2,400/bbl)*(1, 00,000 bbl) =Rs 2,40,000,000.
David Dubofsky and 11- 17 Thomas W. Miller, Jr.

The net payment made (cash out flow for the pay-fixed party) is then Rs 10,000,000. In a different scenario, if the price per barrel will have increased to Rs 2,550/bbl than the pay-fixed party would have received a net inflow of Rs 5,000,000.

Javeria Jaan

OPTION CONTRACTS

DEFINITIONS

Call: The option holder has the right to buy the underlying instrument at the calls exercise (strike) price
Put: The option holder has the right to sell the underlying instrument at the puts exercise (strike) price

Call Options: The buyer of a call option has the right but not the obligation to purchase. The seller of a call option has the obligation to sell. Put Options: The buyer of a put option has the right but not the obligation to sell. The seller of a put option has the obligation to purchase.

OPTION BASICS

The buyer of an option is buying the right, but not the obligation, to buy (call) or sell (put) something at some point in the future.

The seller of an option has an obligation to perform if the buyer exercises the option.

If the buyer lets the option expire, the sellers obligation is dissolved.

OPTION BASICS (CONTINUED)

The sellers compensation for taking on the responsibility is called the premium. The price, if exercised, is called the strike price. Options are strong contracts and can be retraded. The initial buyer has three choices: exercise, let expire, or retrade by selling.

TYPES OF OPTION

1.Exchange-traded options/ listed options Exchange traded options have standardized contracts, and are settled through a clearing house with fulfillment guaranteed by the credit of the exchange. Since the contracts are standardized, accurate pricing models are often available.

Exchange-traded options include stock options bond options and other interest rate options stock market index options or, simply, index options and options on futures contracts callable bull/bear contract

OVER-THE-COUNTER
2.Over-the-counter options/ dealer options OTC options are traded between two private parties, and are not listed on an exchange. The terms of an OTC option are unrestricted and may be individually tailored to meet any business need. In general, at least one of the counterparties to an OTC option is a well-capitalized institution.

CONTINUE.
Option types commonly traded over the counter include:
1. Interest rate options 2. Currency cross rate options 3. Options on swaps or swaptions

OTHER OPTION TYPES

3.Employee stock options which are awarded by a company to their employees as a form of incentive compensation. For example Real estate options are often used to assemble large parcels of land, and prepayment options are usually included in mortgage loans.

OPTION STYLES
These include: European option an option that may only be exercised on expiration. American option an option that may be exercised on any trading day on or before expiry. Bermudan option an option that may be exercised only on specified dates on or before expiration.

Barrier option any option with the general characteristic that the underlying security's price must pass a certain level or "barrier" before it can be exercised. Exotic option any of a broad category of options that may include complex financial structures. Vanilla option any option that is not exotic.

OPTION PARTICIPANTS

Call Buyer Pays premium Has the right to buy

Call Seller Collects premium Has obligation to sell, if assigned Put Seller Collects premium Has obligation to buy, if assigned

Put Buyer Pays premium Has the right to sell

AIMAN FATIMA

FUTURES

WHAT ARE FUTURES??

Futures are contracts to buy or sell a specific commodity on a specific day for a present price.

WHY WERE THEY CREATED?

Futures provide producers, farmers, and end users with the opportunity to hedge their position against large price swings and potentially large losses.

WHO TRADES FUTURES?

Hedgers

(Farmers and Commercials) trade futures to reduce risk.

Example:

Farmers who commit themselves to sell grain at a good price are protected if prices drop.

Large

Speculators (brokerage houses) trade both their own accounts and their clients accounts to capitalize on price swings. Small Speculators (investors) trade futures to capitalize on large moves in the direction of their position.

TRADING FUTURES
When you buy a futures contract, you pay an initial margin (usually between 2% and 10% depending on the client) This installment must remain 100% intact day to day. It can grow, but cannot drop. When you leave the market (i.e. sell it back) it cancels your obligation to buy the commodity on the contract expiration date.

MARKED TO MARKET
Marked to Market means that at the end of the day, the house settles all accounts. If your contract profited on the day, the money is credited to your account when the market closes for the day. If the position went against you, the account is debited that amount.

TYPES OF COMMODITIES

SUBGROUPS

Softs (Food and Fiber) Grains and Oilseeds Livestock Metals

SOFTS

Orange Juice Cocoa Coffee Sugar Cotton (fiber)

GRAINS AND OILSEEDS

Corn Oats Wheat

Soybeans Soybean Oil Soybean Meal

LIVESTOCK
Live Cattle Feeder Cattle Live Hogs Pork Bellies

METALS
Copper Gold Silver Platinum

WHERE ARE FUTURES TRADED?

CONTRACT SPECIFICATIONS
These are the sizes of the contracts. Some examples:

Wheat contract = 5,000 bushels of Wheat 1 Gasoline contract = 42,000 gallons of Gas 1 Sugar contract = 112,000 lbs. Of Sugar

Therefore, if wheat is being traded at $3.20 a bushel, 1 contract = $16,000. A one cent move is equal to $50

SEHRISH KHAN

INTRODUCTION TO FORWARD CONTRACTS

Both futures and forwards specify a trade between two counter-parties:

There is a commitment to deliver an asset (this is the seller, or the short), at a specified forward price. There is a commitment to take delivery of an asset (this is the buyer, or the long), at a specified forward price. At delivery, cash is exchanged for the asset.

Many times, futures contracts and forward contracts are substitutes. However, at other times, the relative costs,liquidity, and convenience of using one market versus the other will differ.

David Dubofsk

FUTURES AND FORWARDS: A COMPARISON TABLE

Futures
Default Risk: What to Trade: The Forward/Futures Price Where to Trade: When to Trade: Liquidity Risk: Borne by Clearinghouse Standardized Agreed on at Time of Trade Then, Marked-to-Market Standardized Standardized Clearinghouse Makes it Easy to Exit Commitment Standardized Standardized Required Offset prior to delivery

Forwards
Borne by Counter-Parties Negotiable Agreed on at Time of Trade. Payment at Contract Termination Negotiable Negotiable Cannot Exit as Easily: Must Make an Entire New Contrtact Negotiable Negotiable Collateral is negotiable Delivery takes place

How Much to Trade: What Type to Trade: Margin Typical Holding Pd.

David Dubofsk

FORWARD CONTRACTS: PAYOFF PROFILES

profit

Long forward

profit

Short forward

F(0,T)

S(T)

F(0,T)

S(T)

The long profits if the spot price at delivery, S(T), exceeds the original forward price, F(0,T).

The short profits if the price at delivery, S(T), is below the original forward price, F(0,T).

David Dubofsk

PROFITS FOR FORWARD CONTRACTS

If S(T) > F(0,T), the long profits by S(T) - F(0,T) per unit, and the short loses this amount. If S(T) < F(0,T), the short profits by F(0,T) - S(T) per unit, and the long loses this amount.

Example: You sell 20 million forward at a forward price of $0.0090/ . At expiration, the spot price is $0.0083/ .

Did you profit or did you lose? How much?

David Dubofsk

USING FORWARDS TO MANAGE RISK

Trading forward and futures contracts (or other derivatives) with the objective of reducing price risk is called hedging.
Not all risks faced by a business can be hedged consider quantity risk.

David Dubofsk

HEDGING FUNDAMENTALS

Hedging with futures/forwards typically involves taking a position in a futures market that is opposite the position already held in a cash market. A Short (or selling) Hedge: Occurs when a firm holds a long cash position and then sells futures/forward contracts for protection against downward price exposure in the cash market.

A Long (or buying) Hedge: Occurs when a firm holds a short cash position and then buys futures/forward contracts for protection against upward price exposure in the cash market. Also known as an anticipatory hedge.
A Cross Hedge: Occurs when the asset underlying the futures/forward contract differs from the product in the cash position. Firms can hold long and short hedges simultaneously (but for different price risks).

David Dubofsk

AN INCOME STATEMENT VIEW

An elementary income statement is: Revenues (= output price times units sold) Costs (= input prices times units of inputs purchased) Profits If output prices decline (all else equal), or if input prices rise (all else equal), then the firms profits will decline.

David Dubofsk

A BALANCE SHEET VIEW

An elementary balance sheet is: Assets Liabilities Owners Equity (stock value)

Any price change that decreases the value of a firms assets, relative to its liabilities, will hurt the stockholders.

Any price change that increases the value of a firms liabilities, relative to its assets, will hurt the stockholders.
David Dubofsk