Derivatives and

21
Hedging

Corporate Financial Management 2e

Emery Finnerty Stowe
© Prentice Hall, 2004
Learning Objectives
Describe four basic types of derivative securities.
Use the Black–Scholes option pricing model (BS–
OPM) to value call and put options on common
stock, and also to value warrants.
Explain how a firm can force conversion of its
outstanding convertible securities.
Explain how a firm can use derivatives to hedge
specific risks.
 Chapter Outline
20.1 Options
20.2 Warrants
20.3 Convertible Securities
20.4 Interest Rate Swaps
20.5 Forwards and Futures
20.6 Hedging
Derivatives, Hedging and the
Principles of Finance
Valuable Ideas
Options
Two-Sided Transactions
Risk-Return Trade-Off
Capital Market Efficiency
Comparative Advantage
Options

A call option gives the holder the right to

buy one share of the underlying stock at a
specified price within a stated time period.
A put option gives the holder the right to
sell one share of the underlying stock at a
specified price within a stated time period.
The fixed price is called the exercise or
strike price.
Some Properties of Options

As stock price increases,

 value of call option increases.
 value of put option decreases.

As exercise price increases,

 value of call option decreases.
 value of put option increases.

As the time to maturity increases,

 value of call option increases.
 value of put option increases.
Option Trading

Exchange listed options

 Chicago Board of Options Exchange (CBOE)
 NYSE
 ASE
 Pacific Stock Exchange
 Philadelphia Stock Exchange

Over-the-counter options
 Non-standardized contracts
Warrants

A warrant is a long-term call option issued

by the firm.
 Entitles holder to buy a fixed number of shares
from the firm, at a stated price, within a stated
time period.
 When a warrant is exercised, the number of
outstanding shares increases.
Convertible Debt

At the option of the bondholder, a convertible

bond can be converted into a pre-specified number
of shares of the firm’s common stock.
Each bond can be converted into common stock at
a stated conversion price.
 Conversion price exceeds issuer’s share price at the
time of issue by about 10% to 20%.
 Conversion price is adjusted for stock splits, stock
dividends, rights offerings, and other distributions.
Convertible Debt

Conversion ratio is the number of shares

that can be purchased with one bond.
Bondholders who convert do not receive
accrued interest.
If bonds are called, conversion option
expires just before the redemption date.
Convertible Debt

The market value of a convertible bond

always exceeds its conversion value (unless
the conversion option is about to expire).
The difference in the market value and the
bond’s conversion value is the time
premium of the conversion option.
 Time premium is zero at option expiration.
Convertible Debt

As long as the underlying stock does not pay

any dividends, bondholders would never
convert voluntarily.
 Sell the bond in the open market since the market
value exceeds the conversion value.
If the stock does pay dividends, bondholders
would not convert as long as the interest on the
bond exceeds the total dividends from the stock.
Forced Conversion

As long as the call price is less than the

market value of the underlying stock,
bondholders will not voluntarily convert.
To force conversion, the firm should call
the bonds when the conversion value
reaches the effective call price.
The effective call price = optional
redemption premium plus accrued interest.
Convertible Preferred Stock

Similar to convertible bonds:

 Convertible preferred stock can be exchanged
into shares of common stock, at the option of
the preferred stockholder.
Convertible exchangeable preferred stock
can be converted into convertible debt.
Black-Scholes Option Pricing
Model
Assumptions:
 The option and the underlying asset trade in perfect markets.
 The returns on the underlying assets are normally
distributed with a constant σ over the life of the option.
 The riskless rate of interest is constant over the option’s life.
 Option contracts are European (cannot be exercised prior to
maturity).
 Underlying asset does not provide any cash flows over the
life of the option.
Black-Scholes Option Pricing
Model
S = Strike price of the call option.
P0 = current value of the underlying asset.
k = riskless APR with continuous compounding.
∆ t = time in years to option expiration.
σ = standard deviation of the (continuously
compounded) returns on the asset.
N(d) = Cumulative distribution function for a
standard normal random variable d.
Black-Scholes Option Pricing Model

The value of the call option, CALL, is given by:

CALL = P0 N (d1 ) − SN (d 2 )e − ∆tk

ln( P0 / S ) + ∆tk σ ∆t
d1 = +
σ ∆t 2

d 2 = d1 − σ ∆t
 Black-Scholes Option Pricing Model

Find the value of a European call option on

Hightone Records. The current stock price is
$48, and the stock’s volatility is 30%. The
risk free rate is 5% per year. The call option
matures in 6 months and has a strike price of
$50.
Black-Scholes Option Pricing Model

ln( P0 / S ) + ∆tk σ ∆t
d1 = +
σ ∆t 2
ln(48 / 50) + .5 × .05 .30 .5
d1 = +
.30 .5 2
d1 = 0.03148

d 2 = d1 − σ ∆t = 0.03148 − .30 .5
d 2 = −0.18065
 Black-Scholes Option Pricing
Model
N(d1) = 0.51256
N(d2) = 0.42832

CALL = P0 N (d1 ) − SN (d 2 )e − ∆tk

CALL = $48 × 0.51256 − $50 × 0.42832e −.5×.05

CALL = $24.6029 − $20.8872

= $3.7156
 Put-Call Parity Relationship

Find the value of a put option on Hightone

Records. The put option also has a strike price
of $50 and expires 6 months from today.
We will use put-call parity:

PUT = CALL + Se − ∆tk − P0

PUT = $3.7156 + $50e −.5×.05 − $48

PUT = $4.4811
Valuing Warrants

Warrants are long-term call options written

by the firm.
When a warrant is exercised, the number of
shares outstanding increases.
Let α be the proportionate increase in the
number of outstanding shares after all
warrants are exercised.
Valuing Warrants

The value of the warrant before it is issued

is simple C/(1+α ) where C is the value of a
call option to buy one share.
After the warrant is issued, an efficient
market will reflect the dilution in the firm’s
stock price, and the warrant’s value is equal
to that of the call option.
Interest Rate Swaps

An interest rate swap obligates two parties to

exchange specified cash flows at specified time
intervals.
The cash flows are determined by two different
interest rates.
The simplest interest rate swap involves swapping
fixed interest rates for floating interest rates, and
vice versa.
Only net cash flows are paid by one party to the
other.
Interest Rate Swaps

The amount on which the interest cash

flows are based is called the notional
amount.
The notional amount is never exchanged.
 Only the interest payments are.
 Interest Rate Swaps

Suppose Hightone Records enters into a fixed

rate - floating rate swap with Megabass Corp.
The notional amount is $100 million.
Hightone agrees to pay 6-month LIBOR rate
and to receive a fixed 8% rate. The 6-month
LIBOR at the initiation of the swap is 6%.
The swap will last for 6 years.
Interest Rate Swaps

The six-monthly cash flow from Hightone’s

point of view is:
$100 million[ (8% - LIBOR)/2 ]
If the LIBOR rate is more than 8%,
Hightone pays cash to Megabass.
If the LIBOR rate is less than 8%, Hightone
receives cash from Megabass.
Interest Rate Swaps

Suppose the LIBOR rate is at the start of the swap is

7%.
 Hightone will receive
$100M[(8%–7%)/2] = $500,000
from Megabass 6 months after the swap initiation date.
Suppose that six months after the swap is initiated,
the LIBOR rises to 9%.
 Hightone will pay
$100M[(8% – 9%)/2] = $500,000
to Megabass six months later.
Why Use Interest Rate Swaps?

Interest rate swaps can be used to convert an

existing fixed rate loan into a floating rate loan
and vice versa.
Suppose 4 years ago, Hightone issued 10 year
$100 million face value bonds at an interest rate of
7.50%.
By entering into a 6-year swap with Megabass,
Hightone has converted its fixed rate loan into a
variable rate loan.
Why Use Interest Rate Swaps?

Hightone pays its bondholders 7.50%.

Hightone receives from Megabass 8.00%.
Hightone pays Megabass 6-month LIBOR.
Net Interest cost to Hightone is
LIBOR – 0.50%.
Thus, Hightone’s existing fixed rate loan
has been swapped into a floating rate loan
at a cost of (LIBOR – 0.50%).
Why Swaps Exist

Comparative advantage
Information asymmetries
Transaction costs
Forward Contracts

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 of the contract are fixed at the time
the contract is entered into:
 The amount of the asset.
 The specified price (the exercise price).

 The delivery date and location.

Forward Contracts

At contract origination, the NPV if the forward

contract is zero.
 The buyer (or seller) will realize a profit only if the
actual market price of the asset is greater (less) than
the exercise price at time of delivery.
Forward contracts are a zero sum game.
 The buyer’s profit (loss) equals the seller’s loss
(profit).
A forward contract has default risk.
Forward Contracts

There are no intermediate cash flows during

the life of the contract.
Most forward contracts require physical
delivery, although some may be cash
settled.
 In a cash settlement, the party incurring the loss
pays the amount of the loss to the counter-
party.
 Forward Contracts

Assume that Tasty Cereal Co. enters into a forward

contract to purchase 50,000 bushels of corn from
Plain State Farms, at a forward price of $2.50 per
bushel. The delivery will take place in 90 days.
What will be Tasty Cereal’s profit in 90 days if the
market price of the corn is:
$2.25 per bushel.
$ 2.75 per bushel.
Forward Contracts

If the market price of corn is $2.25 per

bushel, Tasty Cereal loses $12,500.
 Loss = 50,000×($2.25 – $2.50) = ($12,500)
If the market price of corn is $2.75 per
bushel, Tasty Cereal gains $12,500.
 Gain = 50,000×($2.75 – $2.50) = $12,500
Futures Contracts

Futures contracts are similar to forward

contracts.
A long position in a futures contract obligates
you to take delivery of the underlying asset.
A short position in a futures contract
obligates you to make delivery of the
underlying asset.
The agreed-upon price at which the asset will
be traded in the future is called the futures
price.
Types of Futures Contracts

Grains and oilseeds

 Corn, wheat, soybeans, canola
Livestock and meat
 Cattle, hogs, pork bellies
Food and fiber
 Cocoa, coffee, sugar, orange juice, cotton
Metals and petroleum
 Copper, gold, silver, heating oil, crude oil
Types of Futures Contracts

Currency
 Japanese yen, German mark, Mexican peso, Swiss
franc
Interest rates
 Treasury bills, notes, and bonds, LIBOR, 30-day
federal funds
Stock indices
 S&P 500, S&P midcap 400, NASDAQ 100, Nikkei,
FT-SE 100
Differences between Forward
and Futures Contracts
Forward contract profits (or losses) are recognized
only at maturity. Futures profits (or losses) are
recognized daily.
 Marking to market
Futures contracts are traded on exchanges, while
forward contracts are traded over-the-counter.
Futures contract obligations can be offset by a
reversing trade on the exchange.
Differences between Forward
and Futures Contracts

Active market exist for futures contracts.

Futures contracts have low default risk.
Futures contracts have greater liquidity.
A Treasury Bond Futures
Contract
Underlying asset is a $100,000 par value of a
hypothetical 20 year, 8% U.S. Treasury bond.
The contract (or futures) price is quoted with
respect to this bond.
The actual deliverable asset may be any one of
several eligible Treasury bonds.
 Seller chooses the bond to be delivered.
Settlement is by physical delivery of the bond.
A Treasury Bond Futures
Contract
Suppose the futures price of the bond on
contract origination is 96.
 The price in dollars is 96%($100,000) or
$96,000.
Assume that you go long in a 6-month
futures contract at this price.
A Treasury Bond Futures
Contract
One day after the contract is entered into,
interest rates fall.
 Bond prices will rise.
Suppose the bond price is 96.50.
The long position makes a profit of $500:
 $100,000 (96.50% – 96.0%) = $500.
The short position loses $500.
A Treasury Bond Futures
Contract
Two days after the contract is entered into, interest
rates rise.
 Bond prices will fall.
Suppose the bond price is 95.50.
The long position loses $1,000:
$100,000×(95.50% – 96.50%) = $1,000.
The short position gains $1,000.
Cumulative loss for long position over two days is
$500 (= +$500 – $1,000)
Hedging

A firm engages in hedging to reduce its sensitivity

to changes in the price of a commodity, a foreign
exchange rate, or an interest rate.
Suppose interest rates increase:
 Value of the firm falls.
 Profits can be made on a short position in interest rate
futures.
A perfect hedge neutralizes the effect of changes
in interest rates.
Hedging

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Hedging

Hedging may be accomplished by using:

 Options
 Interest rate swaps

 Futures contracts
 Hedging with Options

Suppose you own 1 share of General Cinema.

The current share price is $50. You purchase
a put option on this stock, with an exercise
price of $50. The put costs $1.00, and expires
in 30 days.
What will be your net profit (loss) under
alternative stock prices 30 days later?
Hedging with Options

Stock Gain on Value of Total Net Gain

Price Stock Put Gain
$48 ($2) $2 $0 ($1)
$49 ($1) $1 $0 ($1)
$50 ($0) $0 $0 ($1)
$51 $1 $0 $1 $0
$52 $2 $0 $2 $1
$53 $3 $0 $3 $2
 Protective Put (Synthetic Call)
$49
The solid green line is
the payoff of a
portfolio long in a
stock and a put.
ST
− $1

$51 It has the same profit

$50 profile as buying a
call option.
– $50
Hedging with Interest Rate
Swaps
A floating interest rate borrower can hedge
against adverse movements in interest rates
by entering into a swap to pay fixed and
receive floating.
Interest Rate Caps and Floors

An interest rate cap pays the holder if a

specified interest rate rises above a
specified value.
 It hedges against a rise in interest rates
An interest rate floor places a lower limit on
interest rates.
 It hedges against a drop in interest rates.
Hedging with Forwards and
Futures
Suppose American Airlines is concerned
about possible future rise in fuel prices.
 Hedge by buying oil futures.
Suppose the U.S. Export Company expects
to receive Japanese yen in the future, and is
concerned about the decline in the value of
the yen.
 Hedge by selling yen futures (short position).
Hedging with Interest Rate
Futures
Interest rate futures can be used to hedge against
adverse movements in interest rates.
Your firm anticipates issuing bonds in the near
future.
 You are concerned about rising interest rates.
 Hedge by going short in Treasury bond futures.
Your firm anticipates a cash inflow in the near
future.
 You are concerned about a drop in interest rates.
 Hedge by going long in Treasury bond futures.
Hedge Ratio

The hedge ratio indicates the number of contracts

to use in the hedge.

Hedge ratio =

Volatility of bond to be hedged

Volatility of hedging instrument
 Hedging with T-Bond Futures

The Mason Co. plans to issue 15 year, $25

million par value bonds in 30 days. Currently,
the interest rate on these bonds is 12%. The
current rate on 20-year, 8% Treasury bonds is
8%. Mason is concerned that interest rates
will rise during this time period. How can it
hedge this risk by selling Treasury bond
futures?
Hedging with T-Bond Futures

Since the current rate on Mason’s bonds is

12%, it can issue 15-year bonds with a
coupon rate of 12% at their par value.
Since the current rate on 20-year, 8%
Treasury bonds is 8%, these bonds are also
selling at their par value.
What would be the value of these bonds if
interest rates rise by 1%?
 Change in Value of Mason
Bonds
If the yield on Mason bonds rises by 1%, the value of 15-year, $100
par, 12% Mason bonds will be $93.4707.

Thus, the bond value would change by

$6.5293 = $100 – $93.4707
if yields rise by 1%.
Change in Value of T-Bonds
If the yield on Treasury bonds rises by 1%, the
value of 20-year, $100 par, 8% Treasury bonds
will be $ 90.7992.

Thus, the bond value would change by

$9.2008 = $100 – $ 90.7992
if yields rise by 1%.
The Hedge Ratio

The hedge ratio is $6.5293/$9.2008 or

0.70965.
Since each Treasury bond futures contract
involves $100,000 par value Treasury bonds,
Mason should sell 177 Treasury bond
contracts:

0.70965($25,000,000/$100,000) = 177
Value of Hedged Position

If interest rates indeed rise by 1%, the

missed issuance opportunity cost to Mason
will be $1,632,325.
$25,000,000×(0.065293) = $1,632,325.

The gain on futures will be $1,628,542.

177($100,000)×(0.092008) = $1,628,542.
Net Effect of Hedge

The net loss to Mason from the rise in

interest rates would be $3,783.
$1,628,542 – $1,632,325 = $3,783.
This loss represents 0.23% of the missed
opportunity cost of $1,632,325.
The gain on futures equals 99.77% of the
missed opportunity cost.