CH 24

Chapter Preview
Starting in the 1970s, the world became a

riskier place for financial institutions. Interest
rate volatility increased, as did the stock and
bond markets. Financial innovation helped
with the development of derivatives. But if
improperly used, derivatives can dramatically
increase the risk institutions face.
2012 Pearson Prentice Hall. All rights reserved.
24-1
Chapter Preview
! In this chapter, we look at the most important
derivatives that managers of financial institution
use to manage risk. We examine how the markets
for these derivatives work and how the products
are used by financial managers to reduce risk.
Topics include:
Hedging
Forward Markets
Financial Futures Markets
24-2
Chapter Preview (cont.)
Stock Index Futures

Options
Interest-Rate Swaps
Credit Derivatives
24-3
Hedging
! Hedging involves engaging in a financial
transaction that reduces or eliminates risk.
! Definitions
long position: an asset which is purchased
or owned
short position: an asset which must be
delivered to a third party as a future date, or an
asset which is borrowed and sold, but must be
replaced in the future
24-4
Hedging
! Hedging risk involves engaging in a
financial transaction that offsets a long
position by taking an additional short
position, or offsets a short position by taking
an additional long position.
! We will examine how this is specifically
accomplished in different financial markets.
24-5
Forward Markets
! Forward contracts are agreements by two
parties to engage in a financial transaction at a
future point in time. Although the contract can be
written however the parties want, the contact
usually includes:
The exact assets to be delivered by one party,
including the location of delivery
The price paid for the assets by the other party
The date when the assets and cash will be exchanged
24-6
Forward Markets
! An Example of an Interest-Rate Contract
First National Bank agrees to deliver $5 million
in face value of 6% Treasury bonds maturing
in 2023
Rock Solid Insurance Company agrees to pay
$5 million for the bonds
FNB and Rock Solid agree to complete the
transaction one year from today at the FNB
headquarters in town
24-7
Forward Markets
! Long Position
Agree to buy securities at future date
Hedges by locking in future interest rate of
funds coming in future, avoiding rate
decreases
! Short Position
Agree to sell securities at future date
Hedges by reducing price risk from increases
in interest rates if holding bonds
24-8
Forward Markets
! Pros
1. Flexible
! Cons
1. Lack of liquidity: hard to find a counter-party
and thin or non-existent secondary market
2. Subject to default riskrequires information to
screen good from bad risk
24-9
The Practicing Manager: Hedging

Interest Rate Risk with Forwards
! First National Bank owns $5 million of
T-bonds that mature in 2029. Because
these are long-term bonds, you are
exposed to interest-rate risk. How do you
hedge this risk?
! Enter into a forward contract with Rock
Solid Insurance company, where Rock
Solid agrees to buy the bonds for $5m.
24-10
The Practicing Manager: Hedging

Interest Rate Risk with Forwards
! First National Bank is hedged against
interest-rate increases
decline of price
bought it at higher amount
losses
! Rock Solid, on the other hand, has

protected itself against rate declines.
rise of price
sold it at a
lower amount
losses
! Both parties can gain or lose, since we

don t know which way rates will actually go
in one year. But both are better off. We ll
review the details a bit more
24-11

! Financial futures contracts are similar to
forward contracts in that they are an
agreement by two parties to engage in a
financial transaction at a future point in
time. However, they differ from forward
contracts in several significant ways.
24-12

! Financial Futures Contract
Specifies delivery of type of security at future date
Arbitrage: at expiration date, price of contract = price of
the underlying asset delivered
i !, long contract has loss, short contract has profit
Hedging similar to forwards: micro versus macro hedge
! Traded on Exchanges
Global competition regulated by CFTC
Commodity Futures Options Trading, Inc. home page
http://www.usafutures.com/
24-13
Example: Hedging Interest

Rate Risk Revisited
! A manager has a long position in Treasury bonds.
She wishes to hedge again interest rate increases,
and uses T-bond futures to do this:
Her portfolio is worth $5,000,000
Futures contracts have an underlying value of $100,000,
so she must short 50 contracts.
24-14
Example: Hedging Interest

Rate Risk
As interest rates increase over the next 12 months, the
value of the bond portfolio drops by almost
$1,000,000.
However, the T-bond contract also dropped almost
$1,000,000 in value, and the short position means the
contact pays off that amount.
Losses in the spot T-bond market are offset by gains
in the T-bond futures market.
You can see all of the details of this example in the
book, on page 596.
24-15

! The previous example is a micro hedge
hedging the value of a specific asset.
Macro hedges involve hedging, for
example, the entire value of a portfolio, or
general prices for production inputs.
24-16

! In the U.S., futures are traded on the CBOT
and the CME in Chicago, the NY Futures
Exchange, and others.
! They are regulated by the Commodity
Futures Trading Commission. The most
widely traded are listed in the Wall Street
Journal, as we see on the next slide.
24-17
Following the News
24-18

! The U.S. exchanges dominated the market
for years. However, this isn t true anymore.
! The London Int l Financial Futures
Exchange trades Eurodollar futures
! The Tokyo Stock Exchange trades Euroyen
and gov t bond futures
! Several others as well, as seen next.
24-19
24-20

! Success of Futures Over Forwards
1. Futures are more liquid: standardized
contracts that can be traded
2. Delivery of range of securities reduces the
chance that a trader can corner the market
3. Mark to market daily: avoids default risk
4. Don t have to deliver: cash netting
of positions
24-21
The Hunt Brothers and the

Silver Crash
! In the early 1980s, the Hunt brothers tried to
corner the silver market by buying 300 million
ounces of silver. The silver price rose from $6 to
$50 an ounce.
! The exchanges steps in, taking action to eliminate
the corner. Silver dropped back to under $10 an
ounce.
! The Hunt brothers lost about $1 billion, a high
price for an excursion in to the silver market.
24-22
Hedging FX Risk
! Example: A manufacturer expects to be
paid 10 million euros in two months for the
sale of equipment in Europe. Currently,
1 euro = $1, and the manufacturer would
like to lock-in that exchange rate.
24-23
Hedging FX Risk
! The manufacturer can use the FX futures market
to accomplish this:
1. The manufacturer sells 10 million euros of futures
contracts. Assuming that 1 contract is for $125,000 in
euros, the manufacturer takes as short position in 40
contracts.
80
2. The exchange will require the manufacturer to deposit
cash into a margin account. For example, the
exchange may require $2,000 per contract, or
$80,000.
$160,000
24-24
Hedging FX Risk
3. As the exchange rate fluctuates during the two
months, the value of the margin account will fluctuate.
If the value in the margin account falls too low,
additional funds may be required. This is how the
market is marked to market. If additional funds are
not deposited when required, the position will be
closed by the exchange.
24-25
Hedging FX Risk
4. Assume that actual exchange rate is 1 euro = $0.96 at
the end of the two months. The manufacturer receives
the 10 million euros and exchanges them in the spot
market for $9,600,000.
5. The manufacturer also closes the margin account,
which has $480,000 in it$400,000 for the changes
in exchange rates plus the original $80,000 required
by the exchange (assumes no margin calls).
6. In the end, the manufacturer has the $10,000,000
desired from the sale.
24-26
Hedging FX Risk
Of course, the exchange rate could have gone the
other way. For example, if the actual exchange rate
is 1 euro = $1.04 at the end of the two months, the
manufacturer will exchange the 10 million euros for
$10,400,000. At the same time, losses in futures
market amount to $400,000, netting the same
$10,000,000. Just as happy? Probably not. Even
though the hedge worked exactly as needed.
24-27
Stock Index Futures

! Financial institution managers, particularly
those that manage mutual funds, pension
funds, and insurance companies, also need
to assess their stock market risk, the risk
that occurs due to fluctuations in equity
market prices.
! One instrument to hedge this risk is stock
index futures.
24-28
Stock Index Futures

! Stock index futures are a contract to buy or sell
a particular stock index, starting at a given level.
Contacts exist for most major indexes, including
the S&P 500, Dow Jones Industrials, Russell
2000, etc.
! The best stock futures contract to use is
generally determined by the highest correlation
between returns to a portfolio and returns to a
particular index.
24-29
Following the News
24-30
Hedging with Stock Index

Futures
! Example: Rock Solid has a stock portfolio
worth $100 million, which tracks closely
with the S&P 500. The portfolio manager
fears that a decline is coming and what to
completely hedge the value of the portfolio
over the next year. If the S&P is currently at
1,000, how is this accomplished?
24-31

Futures
! Value of the S&P 500 Futures Contract =
250 ! index
currently 250 ! 1,000 = $250,000
! To hedge $100 million of stocks that move

1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
sell $100 million of index futures =
400 contracts
24-32

Futures
! Suppose after the year, the S&P 500 is at
900 and the portfolio is worth $90 million.
futures position is up $10 million
! If instead, the S&P 500 is at 1100 and the

portfolio is worth $110 million.
futures position is down $10 million
! Either way, net position is $100 million

24-33

Futures
! Note that the portfolio is protected from downside
risk, the risk that the value in the portfolio will fall.
However, to accomplish this, the manager has
also eliminated any upside potential.
! Now we will examine a hedging strategy that
protects again downside risk, but does not
sacrifice the upside. Of course, this comes at a
price!
24-34
MINI-CASE: Program Trading

and the Market Crash of 1987
! In the aftermath of the Black Monday crash on
October 19, 1987, stock price index futures
markets have been accused of being culprits in
the market collapse.
! Program trading between futures and stock prices
creates a downward spiral. Other experts blame
portfolio insurance, which can have the same
affect.
! Limits on program trading have been implements
to reduce this problem in the future.
24-35
Options
! Options Contract
American: exercised ANYTIME until expiration date

European: exercised ON the expiration date
Right to buy (call option) or sell (put option) an

instrument at the exercise (strike) price up until
expiration date (American) or on expiration
date (European).
! Options are available on a number of

financial instruments, including individual
stocks, stock indexes, etc.
24-36
Options
! Hedging with Options
Buy same number of put option contracts as would sell
of futures
Disadvantage: pay premium
Advantage: protected if i increases, gain on contract
if i falls, additional advantage if macro hedge: avoids
accounting problems, no losses on option
! The next slide highlights these differences

between futures and options
24-37
Options
vs
Futures
24-38
Factors Affecting Premium

1. Higher strike price, lower premium
on call options and higher premium on
put options.
2. Greater term to expiration, higher
premiums for both call and put options.
3. Greater price volatility of underlying
instrument, higher premiums for both call
and put options.
24-39
Hedging with Options

! Example: Rock Solid has a stock portfolio
worth $100 million, which tracks closely with
the S&P 500. The portfolio manager fears
that a decline is coming and what to
completely hedge the value of the portfolio
against any downside risk. If the S&P is
currently at 1,000, how is this accomplished?
24-40

! Value of the S&P 500 Option Contract =
100 ! index
currently 100 ! 1,000 = $100,000
! To hedge $100 million of stocks that move

1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
buy $100 million of S&P put options =
1,000 contracts
24-41

! The premium would depend on the strike price.
For example, a strike price of 950 might have a
premium of $200 / contract, while a strike price of
900 might have a strike price of only $100.
! Let s assume Rock Solid chooses a strike price of
950. Then Rock Solid must pay $200,000 for the
position. This is non-refundable and comes out of
the portfolio value (now only $99.8 million).
24-42

! Suppose after the year, the S&P 500 is at
900 and the portfolio is worth $89.8 million.
options position is up $5 million (since 950
strike price)
in net, portfolio is worth $94.8 million
! If instead, the S&P 500 is at 1100 and the

portfolio is worth $109.8 million.
options position expires worthless, and
portfolio is worth $109.8 million
24-43

! Note that the portfolio is protected from any
downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million.
However, to accomplish this, the manager
has to pay a premium upfront of $200,000.
24-44
Interest-Rate Swaps
! Interest-rate swaps involve the exchange
of one set of interest payments for another
set of interest payments, all denominated in
the same currency.
! Simplest type, called a plain vanilla swap,
specifies (1) the rates being exchanged,
(2) type of payments, and (3) notional
amount.
24-45
Interest-Rate Swap
Contract Example
! Midwest Savings Bank wishes to hedge rate
changes by entering into variable-rate contracts.
! Friendly Finance Company wishes to hedge some
of its variable-rate debt with some fixed-rate debt.
! Notional principle of $1 million
! Term of 10 years
! Midwest SB swaps 7% payment for T-bill + 1%
from Friendly Finance Company.
24-46
Interest-Rate Swap
Contract Example
24-47
Hedging with Interest-Rate

Swaps
! Reduce interest-rate risk for both parties
1. Midwest converts $1m of fixed rate assets to
rate-sensitive assets, RSA, lowers GAP
2. Friendly Finance RSA, lowers GAP
24-48
Hedging with Interest-Rate

Swaps
! Advantages of swaps
1. Reduce risk, no change in balance-sheet
2. Longer term than futures or options
! Disadvantages of swaps
1. Lack of liquidity
2. Subject to default risk
-> similar to forward contracts
! Financial intermediaries help reduce

disadvantages of swaps (but at a cost!)
24-49
Credit Derivatives
! Credit derivatives are a relatively new
derivative offering payoffs based on
changes in credit conditions along a variety
of dimensions. Almost nonexistent twenty
years ago, the notional amount of credit
derivatives today is in the trillions.
24-50
Credit Derivatives
! Credit derivatives can be generally
categorized as credit options, credit swaps,
and credit-linked notes. We will look at each
of these in turn.
24-51
Credit Derivatives
! Credit options are like other options, but
payoffs are tied to changes in credit
conditions.
Credit options on debt are tied to changes in
credit ratings.
Credit options can also be tied to credit
spreads. For example, the strike price can be
a predetermined spread between AAA-rated
and BBB-rated corporate debt.
24-52
Credit Derivatives
! Credit options are like other options, but
payoffs are tied to changes in credit
conditions.
Credit options on debt are tied to changes in
credit ratings.
Credit options can also be tied to credit
spreads. For example, the strike price can be
a predetermined spread between BBB-rated
corporate debt and T-bonds.
24-53
Credit Derivatives
! For example, suppose you wanted to issue
$100,000,000 in debt in six months, and
your debt is expected to be rated single-A.
Currently, A-rated debt is trading at 100
basis points above the Treasury. You could
enter into a credit option on the spread, with
a strike price of 100 basis points.
24-54
Credit Derivatives
! If the spread widens, you will, of course,
have to issue the debt at a higher-thanexpected interest rate. But the additional
cost will be offset by the payoff from the
option. Like any option, you will have to pay
a premium upfront for this protection.
24-55
Credit Derivatives
! Credit swaps involve, for example,
swapping actual payments on similar-sized
loan portfolios. This allows financial
institutions to diversify portfolios while still
allowing the lenders to specialize in local
markets or particular industries.
24-56
Credit Derivatives
! Another form of a credit swap, called a
credit default swap, involves option-like
payoffs when a basket of loans defaults.
For example, the swap may payoff only
after the 5th bond in a bond portfolio
defaults (or has some other bad credit
event).
24-57
Credit Derivatives
! Credit-linked notes combine a bond and a
credit option. Like any bond, it makes
regular interest payments and a final
payment including the face value. But the
issuer has an option tied to a key variable.
24-58
Credit Derivatives
! For example, GM might issue a bond with a
5% coupon rate. However, the covenants
would stipulate that if an index of SUV sales
falls by more than 10%, the coupon rate
drops to 3%. This would be especially
useful if GM was using the bond proceeds
to build a new SUV plant.
24-59
Are derivatives a time bomb?

! In the 2002 annual report for Berkshire
Hathaway, Warren Buffett referred to
derivatives (bought for speculation) as
weapons of mass destruction. (although
also noting that Berkshire uses derivatives).
Is he right?
24-60

! There are three major concerns with the
use of financial derivatives:
Derivatives allow financial institutions to
increase their leverage (effectively changing
their capital), possibly to take on more risk
Derivatives are too complicated
The derivative positions of some banks exceed
their capitalthe probability of failure has
greatly increased
24-61

! As usual, the blanket comments are usually
not accurate. For example, although the
notional amount of derivatives exceeds
capital, often these are offsetting positions
on behalf of clientsthe bank has no
exposure. In other words, you have to look
at each situation individually. Further, actual
derivative losses by banks is small, despite
a few news-worthy exceptions.
24-62

! Of course, the 2007-2009 financial crisis
only further illustrates the problem of
speculative derivatives. AIG, for example,
sought fee revenue from taking the short
side of credit default swaps. Unfortunately,
when housing prices collapsed, they have
to payout on those positions, resulting in
billions in losses (to you me in the end!).
24-63

! In the end, derivatives do have their
dangers. But so does hiring crooks to run a
bank (Lincoln S&L ring a bell). But
derivatives have changed the sophistication
needed by both managers and regulators to
understand the whole picture.
24-64
Chapter Summary
! Hedging: the basic idea of entering into an
offsetting contract to reduce or eliminate
some type of risk was presented.
! Forward Markets: the basic idea of
contracts in this highly specialized market,
as well as a simple example of eliminating
risk was presented.
24-65
Chapter Summary (cont.)

! Financial Futures Markets: these exchange
traded markets were presented, as well as
their advantages over forward contacts.
! Stock Index Futures: the specific
application of stock index futures was
presented, exploring their ability to reduce
or eliminate risk for equity portfolios.
24-66

! Options: these contracts, which give the
buyer the right but not the obligation to act,
were presented, as well as an example
showing their costs.
! Interest-Rate Swaps: the idea of trading
fixed-rate interest payments for floating-rate
payments was presented, as well as the
pros and cons of such contracts.
24-67

! Credit Derivatives: we examine this
relatively new market for hedging the credit
risk of portfolios and the dangers involved.
24-68

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CH 24

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Chapter Preview

Starting in the 1970s, the world became a

2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

Chapter Preview (cont.)

Stock Index Futures

2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

The Practicing Manager: Hedging

The Practicing Manager: Hedging

! Rock Solid, on the other hand, has

! Both parties can gain or lose, since we

Financial Futures Markets

2012 Pearson Prentice Hall. All rights reserved.

Financial Futures Markets

Example: Hedging Interest

2012 Pearson Prentice Hall. All rights reserved.

Example: Hedging Interest

2012 Pearson Prentice Hall. All rights reserved.

Financial Futures Markets

2012 Pearson Prentice Hall. All rights reserved.

Financial Futures Markets

2012 Pearson Prentice Hall. All rights reserved.

Following the News

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Financial Futures Markets

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Financial Futures Markets

2012 Pearson Prentice Hall. All rights reserved.

The Hunt Brothers and the

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2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

2012 Pearson Prentice Hall. All rights reserved.

Stock Index Futures

Stock Index Futures

Following the News

2012 Pearson Prentice Hall. All rights reserved.

Hedging with Stock Index

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Hedging with Stock Index

! To hedge $100 million of stocks that move

Hedging with Stock Index

! If instead, the S&P 500 is at 1100 and the

! Either way, net position is $100 million

Hedging with Stock Index

2012 Pearson Prentice Hall. All rights reserved.

MINI-CASE: Program Trading

American: exercised ANYTIME until expiration date

Right to buy (call option) or sell (put option) an

! Options are available on a number of

! The next slide highlights these differences

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Factors Affecting Premium

Hedging with Options

2012 Pearson Prentice Hall. All rights reserved.

Hedging with Options

! To hedge $100 million of stocks that move

Hedging with Options

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