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Chapter 13 Managing Project Risks

Hedging

Use of financial instruments to reduce or negate the risk by transferring the exposure to another party

Drop in price of the product

Increase in interest

Weakening of the home currency

rates

Derivatives

A financial instrument whose value depends on (or derives from) the price of some underlying quantity, such as a stock price or an interest rate

Swaps

Options

Forwards

Futures

Swaps

A swap contract obligates two parties to exchange specified cash flows at specified intervals. In an interest-rate swap, the cash flows are determined by two different interest rates in the same currency. In a currency swap, the cash flows are based on interest rates in two different currencies. The two parties usually exchange the amounts of the currencies on which the interest rates are based

Interest Rate Swap

Exchange of interest payment obligations

Exchange of coupon payments, not principals Notional principal amount Fixed-rate-floating-rate Floating-rate-floating-rate

Beneficial only if it is superior for each party to a straight borrowing that is identical in design and risk. Deferred-start interest-rate swap that will start on the future date. The anticipated long-term floating-rate financing for the project is put in place enables to fix the interest cost before the long-term loan is even negotiated

Interest Rate Swap

LENDER

LOAN PAY LIBOR+1%
LOAN
PAY LIBOR+1%

BORROWER

PAY 8% RECEIVE LIBOR
PAY 8%
RECEIVE LIBOR

SWAP

COUNTER

PARTY

Net interest rate paid by the borrower is 9%

Value Added by Interest Rate Swaps

Value Added by Interest Rate Swaps

Credit Default Swap

Credit derivative is a privately negotiated contract the value of which is derived from the credit risk of a bond, a bank loan, or some other credit instrument. Credit risk refers to the risk that a security will lose value because of a reduction in the issuer’s capacity to make payments of interest and principal. It refers to the likelihood that the issuer will actually default, that is, fail to make timely payments of principal and interest A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument - typically a bond or loan - goes into default (fails to pay)

How CDS Works?

t= 1 t= 1 2 2 3 3 4 4 5 5 n Buyer Buyer
t= 1
t= 1
2
2
3
3
4
4
5
5
n
Buyer Buyer
Seller
t=0
n
Seller
t=0
n

Credit Insurance

CDS is form of credit insurance Enable market participants to separate credit risk from other types of risk Value of a credit derivative is linked to the change in credit quality of the specified underlying fixed-income security, usually a bond, a note, or a bank loan A deterioration (improvement) in credit quality raises (lowers) the yield investors require and reduces (increases) the price of the bond, other factors remaining the same

Hedging Credit Risk

Lenders and fixed-income investors can hedge their credit risk exposure by purchasing a credit swap linked to the loan Project sponsors or lenders who are concerned about their exposure to the sovereign credit risk of the country in which the project is located can buy a credit swap linked to the sovereign issuer’s outstanding debt

Options

An option gives its holder the right to do something, without the obligation to do it. An option is any right that has no obligation attached to it. A call option is the right to buy an asset. A call option gives its holder the opportunity to benefit from good outcomes. A put option is the right to sell an asset. A put option gives its holder the opportunity to avoid bad outcomes The strike price is the price at which the option holder may buy or sell the underlying asset when the option is exercised.

Options

When exercising an option would provide an advantage over buying or selling the underlying asset in the open market, the option is in-the-money When exercising an option would not provide an advantage over buying or selling the underlying asset currently in the market, the option is out-of-the-money The exercise value (also called intrinsic value) is the amount of advantage an in-the-money option provides over buying or selling the underlying asset currently in the market. An out-of-the-money option has a zero exercise value

Options

An option’s expiration is the point in time the option contract ceases to exist. An American option is an option that can be exercised at any time prior to its expiration. A European option can be exercised only at the end of the contract, not before.

Call Option

Investor buys a European call option to purchase 1 share of Google’s stock at a strike price of $400/share, three months from today. Current spot price of Google stock is $390/share. Option price (premium) is $10/share.

Call Option

If spot price at expiration is less than $400, option is not exercised and investor loses $10 If spot price at expiration is greater than $400, option should be exercised. Suppose, spot price at expiration is $420. Then, investor would exercise the option, by purchasing one Google share at $400, immediately selling it at spot price and realizing a gain of $20. Taking into account initial cost of an option, net profit is $10.

Purchaser a option hopes that price underlying of an of asset the Call Option will
Purchaser
a
option
hopes
that
price
underlying
of an of asset the
Call Option
will
call increase
Profit
30
20
10
370
380
390
400
410
420
430
-10
-20

Terminal

stock

price

Put Option

Investor buys a European put option to sell 1 share of Google’s stock at a strike price of $400/share, three months from today. Current spot price of Google stock is $390/share. Option price (premium) is

$10/share.

Put Option

If spot price at expiration is greater than $400, option is not exercised and investor loses $10 If spot price at expiration is less than $400, option should be exercised. Suppose, spot price at expiration is $380. Then, investor would buy one share of Google stock on the market, and exercise the option to sell the same share for $400, realizing a gain of $20. Taking into account initial cost of an option, net profit is $10.

Purchaser put option hopes that price of a of underlying an asset the will decrease
Purchaser
put
option
hopes
that
price
of a of
underlying
an asset
the will
decrease
Put Option
Profit
370
380
390
400
410
420
430

30

20

10

-10

-20

Terminal

stock

price

Option positions

Option buyer – long position Option seller (writer) – short position Types of option position

Long position in a call option Long position in a put option Short position in a call option Short position in a put option

Long position in a call

Profit 30 20 10 370 380 390 400 410 420 430 Terminal -10 stock price
Profit
30
20
10
370
380
390
400
410
420
430
Terminal
-10
stock
price
-20

Long position in a put

Profit 30 20 10 370 380 390 400 410 420 430 Terminal -10 stock price
Profit
30
20
10
370 380
390
400
410
420
430
Terminal
-10
stock
price
-20

Short position in a call

Profit 30 20 10 370 380 390 400 410 420 430 Terminal -10 stock price
Profit
30
20
10
370 380
390
400
410
420
430
Terminal
-10
stock
price
-20
Short position in a put Profit 30 20 10 370 380 390 400 410 420
Short position in a put
Profit
30
20
10
370
380
390
400
410
420
430
Terminal
-10
stock
price
-20

Option payoffs

 

LONG

SHORT

C

   

A

max (S T – K; 0)

min (K – S T ; 0)

L

L

   

P

   

U

max (K – S T ; 0)

min (S T – K; 0)

T

Option payoffs

C A L L P U T LONG Payoff K S T Payoff K S

C

A

L

L

P

U

T

LONG

Payoff K S T
Payoff
K
S T
Payoff K S T
Payoff
K
S T

SHORT

Payoff K S T
Payoff
K
S T
Payoff K S T
Payoff
K
S T

Warrant

A long-term call option issued by a firm, which entitles the holder to buy shares of the firm’s common stock at a stated price for cash. Often included as a sweetener to a new issue of common stock or a privately placed debt issue A covered call option, because it’s written on un-issued stock

Convertible Bond/Preferred Stock

Entitles the holder to exchange the bond (or preferred share) for a stated number of shares of the issuing firm’s common stock Incorporates a warrant that lets the owner profit if the firm’s share price goes up

Convertible Bonds

Have a coupon rate, maturity, and optional redemption features just like a straight bond Conversion price – price at which a bond can be exchanged for stock, usually exceeds the market share price at the time of bond issue. Conversion ratio - number of shares of common stock into which each bond can be converted

Face amount of the convertible bond

Conversion price

Convertible bonds

Conversion price is usually adjusted for stock splits, stock dividends, rights offerings, and asset distributions by lowering the strike (offering) price Accrued interest is not received, if bond is converted

Value of a convertible bond

Value of a convertible bond

Forward contract

A forward contract obligates the holder to buy a specified amount of a particular asset at a stated price on a particular date in the future. All terms are fixed at the time the forward contract is entered into The specified future price is the exercise price and it’s equal to the expected future price Most forward contracts are for commodities or currencies Most forwards contracts require physical delivery of an asset, although some can provide for cash settlement Gain/loss is realized on settlement date Traded on over-the-counter (OTC) market

Forward contract example

Oil refinery enters into a forward contract with oil producer, to purchase crude oil Quantity: 10,000 barrels Exercise price: $45/barrel Maturity: 90 days Total obligation: $450K Market price of oil after 90 days:

$50/barrel: Oil refinery realizes a profit of $50K $40/barrel: Oil refinery realized a loss of $50K

Futures Contract

Similar to forward contract, except:

Futures are traded on organized exchanges vs. OTC Gains/losses are realized daily

Underlying assets are agricultural commodities, precious metals, industrial commodities, currencies, stock market indexes, common stocks, and interest-bearing securities, such as T-bills, T-notes, T-bond, and Eurodollar deposits Physical asset contracts require physical delivery, currency/security contracts are cash- settled

Futures Contract

Rarely held to maturity Usually closed by reverse trading

Long position in futures is closed, by selling (shorting) an identical contract

Futures prices are limited by price change limits, due to their high volatility

Futures vs. Forwards

Futures have lower default risk

Futures are marked-to-market and settled daily, any loss realized during the day by holder is paid to seller Margin requirements – both parties are required to post a performance bond which is adjusted daily There is a clearinghouse. Each party to a futures transaction really enters into a transaction with the clearinghouse, not directly with each other

Futures are more liquid than forward contracts

A standardized contract Trading on organized exchanges

Futures contract example

A T-bond futures contract Underlying asset: $100,000 value bond, with 20- year maturity and 8% coupon Delivery in 6 months, at a price of 96 (percentage of face value, or $96,000) If interest rates go up:

Value of the bond goes down Value of the futures contract goes down Holder realizes a loss Seller realizes a gain

Hedging

Hedging can be used to reduce the project’s sensitivity to changes in the price of a commodity, a foreign exchange rate, or an interest rate Taking an offsetting position, by buying or selling a financial instruments whose value changes in the opposite direction from the value of an asset being hedged

How a hedge works? Value of the project Value of the project unhedged Value of
How a hedge works?
Value of the project
Value of the project
unhedged
Value of the project
hedged
Interest rates
Value of the hedge
position

Hedging with options

Options provide an opportunity to hedge against a bad outcome while preserving the opportunity to benefit from a good outcome An investor purchases 100 shares of Google at $390/each, and wants to hedge against falling prices A hedge is formed by purchasing a put option Strike price: $390/share Option premium: $20/share

Hedging with options 8000 Gain/Loss Gain/loss Gain/loss w/hedge 6000 on option 4000 Net Gain/loss 2000
Hedging with options
8000
Gain/Loss
Gain/loss
Gain/loss
w/hedge
6000
on option
4000
Net
Gain/loss
2000
0
320 330 340 350 360 370 380 390 400 410 420 430 440 450 460
-2000
Stock Price
-4000
-6000
Gain/loss
on stock
-8000

Interest Rate Cap

Call option on a floating exchange rate, with a fixed cap (strike price) Hedges against a rise in interest rates Assume a $100 loan, with floating-rate interest equal to LIBOR An interest-rate cap with 8% cap is used to hedge

Interest Rate Cap $4.0 $2.0 $0.0 1 2 3 4 5 6 7 8 9
Interest Rate Cap
$4.0
$2.0
$0.0
1
2
3
4
5
6
7
8
9
10
11
12
13
($2.0)
($4.0)
Interest payable
Cap contract payment
Net interest payable
($6.0)
($8.0)
($10.0)
($12.0)

Interest Rate Floor

Put option on a floating exchange rate, with a strike price equal to fixed cap rate Hedges against a fall in interest rates Assume a $100 loan receivable, with floating-rate interest equal to LIBOR An interest-rate floor contract with 8% cap is used to hedge

Interest Rate Floor $11.00 $9.00 $7.00 Interest receivable Cap contract payment $5.00 Net interest received
Interest Rate Floor
$11.00
$9.00
$7.00
Interest receivable
Cap contract payment
$5.00
Net interest received
$3.00
$1.00
1
2
3
4
5
6
7
8
9
10
11
12
13
($1.00)

Interest Rate Collar

A combination of call and put option on a floating exchange rate, with a strike price equal to fixed cap rate Hedges against rates falling outside a particular range Assume a $100 loan receivable, with floating- rate interest equal to LIBOR, plus $100 loan payable with floating-rate interest equal to US Prime A 6%/8% interest rate collar contract is used to hedge

Interest Rate Collar Interest receivable Net interest received Cap contract payment Interest payable Cap contract
Interest Rate Collar
Interest receivable
Net interest received
Cap contract payment
Interest payable
Cap contract payment
Net gain/loss
Net interest payable
$8.00
$3.00
1
2
3
4
5
6
7
8
9
10
11
12
13
($2.00)
($7.00)
($12.00)

Hedging with forwards/futures

Hedge Ratio

Number of

contracts

Volatility of bond to be hedged

=

Hedge

= Ratio

Volatility of hedging instrument

x

Principal amount to be hedged

Par value of hedging instrument

Hedging with forwards/futures example

Suppose, a mining company plans to issue $50 million of bonds, at 10% coupon rate, and a maturity of 30 years to finance a new project. It needs one month to prepare all necessary documentation. The company is concerned, that interest rates can go up by 100 basis points (1%) before it can sell the issue. $100 par value bond, with $10 coupon 30 maturity with semi-annual coupon payment

Volatility of the bond If new-issue rates increase to 11%, then 60 5 100 PV
Volatility of the bond
If new-issue rates increase to 11%, then
60
5
100
PV
= ∑
+
10%
t
60
(1
+
0.55)
(1
+
0.55)
t= 1
5
1
100
=
×
1
− 
+
(
0.55
)
60
0.55
1
+
(
)
60
1
+
0.55
 
  
=
87.2493
+
4.0258
=
91.2751
Change in value is 8.7249 (100 − 91.2751).

Hedging instrument

Mining company could sell Treasury bond futures to hedge this risk. It estimates that the yield on an 8% 20-year Treasury bond would also increase by 1%, from 9%, currently, to 10% Each futures contract covers $100,000 principal amount of bonds

Volatility of the hedging instrument

Value of a T-bond at 9%

Volatility of the hedging instrument Value of a T-bond at 9% Value of a T-bond at

Value of a T-bond at 10%

of the hedging instrument Value of a T-bond at 9% Value of a T-bond at 10%

Change in value is 7.9583 (90.7992 − 82.8409)

Hedge ratio and number of contracts

Hedge ratio and number of contracts Mining Co. needs to sell short 1.0963 8% Treasury bonds

Mining Co. needs to sell short 1.0963 8% Treasury bonds for each bond to be hedged

Hedge ratio and number of contracts Mining Co. needs to sell short 1.0963 8% Treasury bonds

Verification

If interest rates rise by 1%, mining company will forego an opportunity cost of 0.087249(50,000,000) = $4,362,450 However, the short position in T-bonds will earn a profit on the futures contracts equal to 548(0.079583)100,000 = $4,361,148

Foreign Exchange Market

Types of FX transactions/contracts

Spot transactions Forward transactions

Currency

futures

Currency

swaps

Currency

options

Currency forwards/futures

A currency forward contract covers the purchase and sale of a specified currency for future delivery based on a price (the exchange rate) that is agreed to today Forward premium/discount

Reflects market expectations of exchange rates at futures dates

Useful when hedging foreign exchange risk exposures that are certain in amount and timing

Hedging FX risk with forwards

Boeing signed a contract with British Airways for delivery of two 777 jets a year from today, with a total contract value of £200 million. Expected 1 year FX rate is $1.50/£, expected contract value is $300 million Suppose, after 1 year, FX rate is $1.45/£, BA will still pay £200 million, however, Boeing will receive $290 million.

Hedging FX risk with forwards

Boeing sells a 1-year forward contract for delivery of £200 million at an exchange rate of $1.5/£

Spot FX rate

Value of original

Gain/loss on

Net realized

contract, millions

forward contract

USD value

£1

=

$ 1.40

£200

=

$ 280

$

20

$

300

£1

=

$ 1.45

£200

=

$ 290

$

10

$

300

£1

=

$ 1.50

£200

=

$ 300

$

-

$

300

£1

=

$ 1.55

£200

=

$ 310

$

(10)

$

300

£1

=

$ 1.60

£200 =

$ 320

$

(20)

$

300

Currency Swap

Exchange of a series of specified payment obligations denominated in one currency for payment obligations denominated in the other One party generally pays the other the difference in value caused by changes in the exchange rate

Currency Swap Example

A UK firm can borrow in GBP, and would like to invest in the US A US firm can borrow in USD, and would like to invest in the UK US firm borrows $100 mil. for 10 years, at 9% UK firm borrows £70.82 mil. For 10 years at 12% Principal and interest payments are swapped During the life of the loan, companies exchange coupon payments At maturity, principal amounts are exchanged

Currency options

The right to buy (in the case of a call option) or sell (for a put option) a specified amount of a particular foreign currency at a stated price within a specified time period The maximum loss is limited to the cost of the option

Hedging FX risk with options

Suppose, in Boeing/BA example, Boeing is just one of the bidders, along with Airbus. BA requires an uncertain length of time to study the bids. Boeing wants to hedge the currency exposure, in case BA awards the contract. With forwards/futures, Boeing will take on obligation to deliver currency, whether it wins the contract or not Currency option hedging gives the flexibility, at a price of the option premium

Corporate Use of Hedging

Firm size

Large firms: more than 80% hedge Small firms: approx 10% hedge

Industry

Mining and primary producers companies

Firms that hedge have

Higher leverage Greater interest rate or foreign exchange exposure Lower liquidity More research and development spending