Derivatives and Hedgings

BUSM4161 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 University©Aug-18 2
Topic Outline
• Derivatives, Hedging and • Duration hedging
Risk • Swap contracts
• Forward Contracts • Actual use of Derivatives
• Futures contracts
• Hedging
• Interest rate futures

contracts
3
3
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
o It’s not a option: both parties are expected to hold up

their end of the deal
o If you have ever ordered a textbook that was not in

stock, you have entered into a forward contract.
4
4
Futures Contracts
• A future contract is like a forward contract
o It specifies that a certain commodity will be

exchanged at a specified time in the future at a price
specified today
• A future contract is different from a forward:
o Futures are standardized contracts trading on

organized exchanges with daily resettlement
(“marking to market”) through a clearing house.
5
5
Futures Contracts 2
• Standardizing Features
o Contract Size
o Delivery Month
• Daily resettlement
o Minimizes the chance of default
• Initial Margin
o About 4-10% of contract value
o Cash or T-bills held in a street name at your brokerage

6
Daily Resettlement: An Example
Suppose you want to speculate on a rise in the $/¥
exchange rate (specifically, you think that the dollar will
appreciate).
7
Suppose you want to speculate on a rise in the $/¥
Dailyrate
exchange Resettlement: An
(specifically, you think Example
that the dollar will2
appreciate).
Currency per
U.S. $ equivalent U.S. $
Wed Tue Wed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1-month forward 0.006993007 0.007042254 143 142
3-months forward 0.006666667 0.006711409 150 149
6-months forward 0.00625 0.006289308 160 159
Currently $1 = ¥140.
The 3-month forward price is $1=¥150.
8
Daily Resettlement: An Example 3
• • Currently
Currently $1$1 == ¥140,
¥140,andandit appears
it appears thatthat
the dollar
the is
dollar is strengthening.
strengthening.
• • IfIfyou
youenter intoa a3-month
enter into 3-month futures
futures contract
contract to sell to
¥ at
sell
the¥rate
at the
of $1rate of $1
= ¥150 you= will
¥150 you
profit willyen
if the profit if
the yen depreciates. The contract size is
depreciates. The contract size is ¥12,500,000
¥12,500,000
• • Your
Yourinitial
initial margin
marginisis4%4%ofofthethe
contract
contractvalue:
value:
$1
$3,333.33 = 0.04 × ¥12,500,000 ×
¥150
9
• If tomorrow the futures rate closes at $1 = ¥149, then
your position’s value drops (¥ appreciated).
If tomorrow the futures rate closes at $1 = ¥149,
• Your
then youroriginal agreement
position’s valuewas to sell
drops (¥ ¥12,500,000 and
appreciated).
receive $83,333.33:
Your original agreement was to sell ¥12,500,000
and receive $83,333.33:
$1
$83,333.33 = ¥12,500,000 ×
¥150
But, ¥12,500,000 is now worth $83,892.62:
$1
$83,892.62 = ¥12,500,000 × 10
then your position’s value drops (¥ appreciated).
our original agreement was to sell ¥12,500,000
and receive $83,333.33:
Daily Resettlement: An Example
$1 5
$83,333.33 = ¥12,500,000 ×
¥150
• But, ¥12,500,000 is now worth $83,892.62:
But, ¥12,500,000 is now worth $83,892.62:
$1
$83,892.62 = ¥12,500,000 ×
¥149
You lost
You have have lost $559.29
$559.29 overnight.overnight.
11
• The $559.29 comes out of your $3,333.33 margin
• The $559.29
account, comes
leaving out of your $3,333.33
$2,774.04.
margin account, leaving $2,774.04.
• This is short of the $3,355.70 required for a new
• This is short of the $3,355.70 required for a
position.
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. 12
• 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.
13
Selected Futures Contracts
Contract Contract Size Exchange
Agricultural
Corn 5,000 bushels Chicago BOT
Wheat 5,000 bushels Chicago & KC
Cocoa 10 metric tons CSCE
OJ 15,000 lbs. CTN
Metals & Petroleum
Copper 25,000 lbs. CMX
Gold 100 troy oz. CMX
Unleaded gasoline 42,000 gal. NYM
Financial
British Pound £62,500 IMM
Japanese Yen ¥12.5 million IMM
Eurodollar $1 million LIFFE 14
14
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.
15
Hedging
• Two counterparties with offsetting risks can eliminate
risk.
o 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

16
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 X .05 X 10 = $12,500
• If prices decrease by 5 cents, your loss is:
Loss = 25,000 ><( -.05) X 10 = -$12,500

17
Hedging: How many contracts?
• You are a farmer, and you will harvest 50,000 bushels
of corn in 3 months. You want to hedge against a price
decrease. Corn is quoted in cents per bushel at 5,000
bushels per contract. It is currently at $2.30 cents for a
contract 3 months out, and the spot price is $2.05.
18
price decrease. Corn is quoted in cents per bushel
at 5,000 bushels per contract. It is currently at
$2.30 cents for a contract 3 months out, and the
Hedging: How
spot price is $2.05.
many contracts? 2
To•hedge, you will
To hedge, you sell 10 corn
will sell futures
10 corn contracts:
futures contracts:
50,000 bushels
10 contracts =
5,000 bushels per contract
Now you can quit worrying about the price of corn
• Now you can quit worrying about the price of corn and
and get back to worrying about the weather.
get back to worrying about the weather.
19
Interest Rate Futures Contracts
• Pricing of Treasury Bonds
• Pricing of Forward Contracts
• Futures Contracts
• Hedging in Interest Rate Futures
20
Pricing of Treasury Bonds
• Consider
Consider a Treasury
a Treasury bond bond
thatthat pays
pays a semiannual
a semiannual
coupon of $C
coupon of for thethe
$C for next T years:
next T years:
• –The
Theyield
yieldtotomaturity
maturityis Ris R
C C C CF
…
0 1 2 3 2T
• Value
Value of the T-bond
of the T-bondunder
underaaflat
flatterm
term structure
structure = PV of
= PV of face value + PV of coupon payments
face value + PV of coupon payments
21
Pricing of Treasury Bonds 2
• If the term
Consider structure
a Treasury of interest
bond that paysrates is not flat, then we
a semiannual
coupon
needofto$C for thethe
discount next T years:at different rates
payments
If the term structure of interest rates is not flat,
–depending
The
thenyield to maturity
we need
upon discountisthe
tomaturity. R payments at
C Cupon maturity. C  F
C depending
different rates
C C C … CF
…
0 1 2 3 2T
0 1 2 3 2T
• Value offace
= PV of the T-bond under
value + PV a flat term
of coupon structure
payments
= PV of=face
PV of face value + PV of coupon payments
value + PV of coupon payments
C C C CF
PV    
(1  R1 ) (1  R2 ) (1  R3 )
2 3
(1  R2T )T
22
Pricing of Forward Contracts
An An
N-period forward
N-period forwardcontract
contract on thatT-Bond:
on that T-Bond:
An N-Period forward contract on that T-Bond:
 Pforward
PforwardCC CC CC CCFF
…
…
0 0 N N N+1 N+1 N+2 N+2 N+3
N+3 N+2T
N+2T
CanCan
be be valued
valued asasthe
thepresent
present value
value of
of the
theforward
forwardprice.
price.
Can be valued as the present value of the forward price.
PPforward
PV 
PV  (1  R )NN
forward
(1  RNN )
C C C CF
C  C  C    CF
(1  RN 1) (1  RN  2 2) 2 (1  RN 3 )33   (1  RN  2T )T T
PV(1 R ) (1  R ) (1R R) NN 3 ) (1  RN  2T )
PV  N 1 N 2 (1 N
(1  RN ) N
23
Pricing of Futures Contracts
• A pricing equation given above will be a good
approximation
• The only real difference is the daily resettlement.
24
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.
25
Duration Hedging
• As an alternative to hedging with futures or forwards,
one can hedge by matching the interest rate risk of
assets with the interest rate risk of liabilities.
• Duration is the key to measuring interest rate risk.
RMIT University©Aug-18
26
Duration Hedging 2
• Duration measures the combined effect of maturity,
coupon rate, and YTM on a bond’s price sensitivity to
interest rates.
o Measure of the bond’s effective maturity
o Measure of the average life of the security
o Weighted average maturity of the bond’s cash flows
27
Duration Formula
PV (C1 ) 1  PV (C2 )  2    PV (CT )  T

D
PV
N
Ct  t
 (1  R ) t
D  tN1
Ct

t 1 (1  R )
t
28
Calculating Duration: Example
• Calculate the duration of a three-year bond that pays a
semiannual coupon of $40 and has $1,000 par value
then the YTM is 8%.
29
Calculating Duration: Example 2
Years Cash flow Factor Value /Bond price
0.5 $40.00 0.96154 $38.46 0.0192
1 $40.00 0.92456 $36.98 0.0370
1.5 $40.00 0.88900 $35.56 0.0533
2 $40.00 0.85480 $34.19 0.0684
2.5 $40.00 0.82193 $32.88 0.0822
3 $1,040.00 0.79031 $821.93 2.4658
$1,000.00 2.7259 years
Bond price Bon duration
Duration is expressed in units of time, usually years
30
Duration
• Properties:
o Longer maturity, longer duration
o Duration increases at a decreasing rate
o Higher coupon, shorter duration
o Higher yield, shorter duration
• Zero coupon bond: duration = maturity
31
Swaps Contracts
• In a swap, two counterparties consent to acontractual
arrangement wherein they agree to exchange cash
flows at periodic intervals.
o 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.
o Cross-Currency interest rate swap:

• This is often called a currency swap; fixed for fixed rate
debt service in two (or more) currencies. 32
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.
o As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap.
o 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. 33
An Example of an 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.
o Bank A is considering issuing 5-year fixed-rate

Eurodollar bonds at 10 percent.
o It would make more sense to for the bank to issue

floating-rate notes at LlBOR to finance floating-rate
Eurodollar loans.
34
2
• Firm B is a BBB-rated U.S. company. It needs
$10,000,000 to finance an investment with a five-year
economic life.
o Firm B is considering issuing 5-year fixed-rate

Eurodollar bonds at 11.75 percent.
o Alternatively, firm B can raise the money by issuing

5- year floating-rate notes at LIBOR + 1/2 percent.
o Firm B would prefer to borrow at a fixed rate.

35
3
• The borrowing opportunities of the two films are:
Company B Company A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
36
4
The swap bank makes this offer to Bank A: You pay
LIBOR - 1/8% per year on $10 million for 5 years, and we
will pay you 10 3/8% on $10 million for 5 years
Swap The swap bank make

Swap Bank this offer to Bank A:
Bank You pay LIBOR – 1/
10 3/8%
per year on $10 millio
LIBOR – 1/8% for 5 years, and we w
Bank pay you 10 3/8% on $
million for 5 years
A
37
5
• Here’s what’s in it for Bank A: They can borrow
externally at 10% fixed and have a net borrowing
position of
-10 3/8% + 10 + (LIBOR -1/8) = LIBOR - 1/2 %, which is

1/2 % better than they can borrow floating without a swap.
38
6
½% of $10,000,000 =
½% of $10,000,000 = $ $50,000. That’s quite
Swap H
a cost savings per year
50,000. That’s quite a cost for 5 years. Swap Bank T
Bank 10
saving per year for 5 years 10 3/8% bo
LIBOR – 1/8% -1
Bank L
10% be
A fl
COMPANY B
Company B Company
Fixed rate
A 11.75%
Floating rate LIBOR + .5%
Floating rate LIBOR + .5% LIBOR 39

7
• The swap bank makes this offer to company B: You pay
us 10 ½% per year on $10 million for 5 years, and we
will pay you LIBOR -1/4 % per year on $10 million for 5
The swap bank
years.
makes this offer to
Swap
company B: You Swap Bank
pay us 10½% per Bank
year on $10 million 10 ½%
for 5 years, and we LIBOR – ¼%
will pay you B Company A
Company
Company
Company
LIBOR –11.75%
Fixed rate
¼ % per 10%
Floating rate LIBOR + .5% LIBOR B
B
year on $10 million 40
8
Here’s what’s in it for B:
They cam borrow externally at LIBOR + ½% and have a

net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR -
¼ ) = 11.25% which is ½ % better than they can borrow
floating.
41
9
• ½ % of $10,000,000 = $50,000 that’s quite a cost
saving per year for 5 years.
Here’s what’s in it for B:
½ % of $10,000,000 =
Swap $50,000 that’s quite a cost
Swap Bank
savings per year for 5
Bank
years.
They can borrow externally at 10 ½%
LIBOR + ½ % and have a net LIBOR – ¼%
borrowing position of Company

Company LIBOR
Company B Company A + ½%
10½Fixed
+ (LIBOR
rate +11.75%
½ ) - (LIBOR -10%
¼ ) = 11.25% B
B
which is ½%
Floating rate better
LIBORthan they canLIBOR
+ .5% borrow floating.
COMPANY B BANK A
42
10
• The swap bank makes money too: ¼ % of $10 million =
$25,000 per year for 5 years.
The swap bank makes money too. ¼% of $10 million
Swap = $25,000 per year
Swap Bank for 5 years.
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
Company
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
LIBOR - 1/8 - [LIBOR - ¼ ]
A =10
1/8½ - 10 3/8 = 1/8 B
B
10 ½ - 10 3/8 = (1/8) / (¼)
¼ 43
COMPANY B BANK A
11
• The swap bank makes ¼%: A saves ½%; B saves ½%
The swap bank makes money too. ¼% of $10 million
Swap = $25,000 per year
Swap Bank for 5 years.
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
Company
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
A 10 ½ - 10 3/8 = 1/8 B
B
Company B ¼ A
Company
Fixed rate COMPANY
11.75% B BANK
10% A
Floating
Fixed raterate LIBOR + .5%
11.75% LIBOR
10%
44
Floating rate LIBOR + .5% LIBOR
An Example of a Currency Swap
• Suppose a U.S. MNC wants 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
o This will give them exchange rate risk: financing a
sterling project with dollars.
• They could borrow pounds in the internationalbond

market, but pay a premium since they are not as well
known abroad. 45
An Example of a Currency Swap 2
• 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 $0($/£) = $1.60/£, the US.

firm needs to find a British firm wanting to finance dollar
borrowing in the amount of $16,000,000.
46
• 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 other’s

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%
47
Swap
Swap Bank
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
Firm A Firm B
A B
$ £
Company B
$10.0% 12.0%
£
Company B 10.0% 12.0%
48
A’s net position is to borrow at £11%. A saves £.6%
Swap
Swap Bank
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
Firm A Firm B
A B
$$ £ £
Company
Company A A 8.0%
8.0% 11.6% 11.6%
Company
Company B B 10.0%
10.0% 12.0% 12.0%
49
B’s net position is to borrow at £9.4%. A saves £.6%
Swap
Swap Bank
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
Firm A Firm B
A B
$$ £ £
Company
Company A A 8.0%
8.0% 11.6% 11.6%
Company
Company B B 10.0%
10.0% 12.0% 12.0%
50
The swap bank makes money too: 1.4% of $16 million
financed with 1% of £10 million per year for 5 years.
A S0 ($/ £) = $1.60/ £, that is a gain of $64,00 per year for

5 years. The swap bank faces exchange rate risk, but
maybe they can lay it off (in another swap)
Swap
Swap Bank $ £
Bank Company A 8.0% 11.6%
$8% $9.4%
Company B 10.0% 12.0%
£11% £12%
$8% Firm Firm £12%
Firm A Firm B
A B
$ £
Credit Default Swaps
• Counterparty # 1 (protection buyer) makes aperiodic
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.
52
Variations of Basic Swaps
• Currency Swaps
o fixed for fixed
o fixed for floating
o floating for floating
o amortizing
53
Variations of Basic Swaps 2
• Interest Rate Swaps
o zero-for floating
o floating for floating
• Exotics
o For a swap to be possible, two humans must like the

idea. Beyond that, creativity is the only limit.
54
Risks of Interest Rate and Currency
Swaps
• Interest Rate Risk
o Interest rates might move against the swap bank

after
o it has only gotten half of a swap on the books, or if it
o has an unhedged position.
• Basis Risk
o If the floating rates of the two counterparties are no

pegged to the same index
55
Swaps 2
• Exchange Rate Risk
o In the example of a currency swap given earlier, the

swap bank would be worse off if the pound
appreciated.
• Credit Risk
o This is the major risk faced by a swap dealer—the

risk that a counterparty will default on its end of the
swap.
56
Swaps 3
• Mismatch Risk
o It is hard to find a counterparty that wants to borrow

the right amount of money for the right amount of
time.
• Sovereign Risk
o The risk that a country will impose exchange rate

restrictions that will interfere with performance on
the swap.
57
Pricing a Swap
• A swap is a derivative security, so it can be priced in
terms of the underlying assets:
o Plain vanilla fixed for floating swap gets valued just

like a bond.
o Currency swap gets valued just like a nest of

currency futures.
58
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.
59
Quick Quiz
• Explain the differences between forward and futures
contracts.
• Explain the process of valuing a futures contract.
• Explain why/how corporations would use futures

contracts.
60

Derivatives and Hedgings

Transféré par

Informations du document

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

Derivatives and Hedgings

Transféré par

Droits d'auteur :

Formats disponibles

BUSM4161 Managerial Finance

Topic 11: Derivatives and Hedging Risk

• Understand how derivatives can be used to hedge risks

• Interest rate futures

o It’s not a option: both parties are expected to hold up

o If you have ever ordered a textbook that was not in

o It specifies that a certain commodity will be

• A future contract is different from a forward:

o Futures are standardized contracts trading on

o Minimizes the chance of default

o About 4-10% of contract value

o Cash or T-bills held in a street name at your brokerage

This is usually done with a reversing trade.

• Open interest is a good proxy for the demand for a

• Some refer to open interest as the depth of the market.

o For example, if a wheat farmer and a flour mill enter

• Hedgers can also transfer price risk to speculators, who

• Speculating: Long vs. Short

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

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

• If prices decrease by 5 cents, your loss is:

Loss = 25,000 ><( -.05) X 10 = -$12,500

• Pricing of Forward Contracts

• Hedging in Interest Rate Futures

• The only real difference is the daily resettlement.

• It may be difficult to find a counterparty in the forward

• It is likely to be easier and cheaper to use interest rate

• Duration is the key to measuring interest rate risk.

o Measure of the bond’s effective maturity

o Measure of the average life of the security

o Weighted average maturity of the bond’s cash flows

PV (C1 ) 1  PV (C2 )  2    PV (CT )  T

o Longer maturity, longer duration

o Duration increases at a decreasing rate

o Higher coupon, shorter duration

o Higher yield, shorter duration

• Zero coupon bond: duration = maturity

o There are two types of interest rate swaps:

o Cross-Currency interest rate swap:

• The swap bank can serve as either a broker or a

o As a dealer, the swap bank stands ready to accept either

• Bank A is a AAA-rated international bank located in the U.K.

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

o It would make more sense to for the bank to issue

o Firm B is considering issuing 5-year fixed-rate

o Alternatively, firm B can raise the money by issuing

o Firm B would prefer to borrow at a fixed rate.

Swap The swap bank make

-10 3/8% + 10 + (LIBOR -1/8) = LIBOR - 1/2 %, which is

Floating rate LIBOR + .5% LIBOR 39

They cam borrow externally at LIBOR + ½% and have a

LIBOR + ½ % and have a net LIBOR – ¼%

borrowing position of Company

LIBOR – 1/8% LIBOR – ¼%

LIBOR – 1/8% LIBOR – ¼%

• They could borrow dollars in the U.S. where they are

• They could borrow pounds in the internationalbond

• If the spot exchange rate is $0($/£) = $1.60/£, the US.

• Both firms wish to finance a project in each other’s

A S0 ($/ £) = $1.60/ £, that is a gain of $64,00 per year for

• In exchange, counterparty #2 agrees to pay for a

• Historically, these contracts were traded on a

o fixed for fixed