M26 Mish1520 06 PPW C25

Chapter 25
Hedging with
Financial
Derivatives
Chapter Preview
Starting in the 1970s, the world became a
riskier place for financial institutions.
Interest rate and exchange 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.
Copyright 2009 Pearson Prentice Hall. All rights reserved.
25-2
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
25-3
Chapter Preview (cont.)

Stock Index Futures
Options
Interest-Rate Swaps
Credit Derivatives
25-4
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
25-5
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.
25-6
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 contract
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
25-7
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
25-8
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
25-9
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
25-10

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.
25-11

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
25-12
Example: Hedging Interest Rate Risk

A manager has a long position in Treasury
bonds. She wishes to hedge against
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.
25-13
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.
25-14

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.
25-15
Following the News
25-16
Widely Traded Financial

Futures Contracts
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.
25-18
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
80 contracts.
2. The exchange will require the manufacturer to
deposit cash into a margin account. For example,
the exchange may require $1,000 per contract, or
$80,000.
25-19
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 (margin call). 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.
25-20
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.
25-21
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.
25-22
Stock Index Futures

Stock index futures are a contract to buy or sell
a particular stock index, starting at a given level.
Contracts exist for most major indexes, including
the S&P 500, Dow Jones Industrials, Russell
2000, Hang Shen Index, Huseng 300 Index, 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.
25-23
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 wants 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?
25-24

Value of the S&P 500 Futures Contract =
250 index
currently 250 x 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
25-25

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
25-26

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 against downside risk, but does not
sacrifice the upside. Of course, this comes at
a price!
25-27
Options
Options Contract
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.
25-28
Options
Hedging with Options
Buy same number of put option contracts as
would sell of futures
Disadvantage: pay premium
Advantage: protected if i increases and price
declines
if i decreases and price increases

no losses on option
25-29
Options
Profit Profiles for Calls

Profit
Call Holder
Call Writer
Stock Price
Profit Profiles for Puts

Profits
Put Writer
0
Put Holder
Stock Price
Protective Put Profit
Profit
Stock
Protective
Put Portfolio
-P
ST
Covered Call Profit

Profit
-P
Stock
Covered
Call
Portfolio
ST
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.
25-35

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 want 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?
25-36

Value of the S&P 500 Option Contract =
100 index
currently 100 x 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
25-37

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.
Lets 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).
25-38

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
25-39

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.
25-40
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.
25-41
Mismatch in durations of Mutual

savings bank and Finance company
A mutual bank usually has long-term assets such as 30year mortgage and short-term liabilities such as 1-year
time-deposits
A finance company usually has short-term assets such as
3-year automobile loan and long-term liability such as
issue of 30-year bond
Both mutual savings bank and finance company have
interest rate risk
If the market short-term interest rate increases
(decreases), the saving bank (finance company) will suffer
25-42
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 fixedrate debt.
Notional principle of $1 million
Term of 10 years
Midwest SB swaps 7% payment for T-bill + 1%
from Friendly Finance Company.
Interest-Rate Swap Contract Example
25-44
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 $1 m of rate sensitive
assets, RSA, to fixed rate assets, lowers
GAP
25-45
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
Financial intermediaries help reduce

disadvantages of swaps (but at a cost!)
25-46
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.
25-47
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.
25-48
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.
25-49
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.
25-50
Credit Derivatives
For example, suppose you wanted to issue
$100 million 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.
25-51
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.
25-52
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.
25-53
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).
25-54
CDS and Systemic Risks: Domino

Model
Figure 1
claim
Bank A
A
claim
Bank B
L
claim
Bank C
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.
25-56
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.
25-57
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?
25-58

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 capital the probability of failure has
greatly increased
25-59

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
clients the bank has less exposure. In other
words, you have to look at each situation
individually.
However, the experience of 2009-09 suggests
that derivatives markets without proper
regulation could lead to crisis
25-60

In the end, derivatives do have their
dangers. But so does hiring crooks to run
a bank (Bernard Madoff rings a bell). But
derivatives have changed the
sophistication needed by both managers
and regulators to understand the whole
picture.
25-61

M26 Mish1520 06 PPW C25

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

M26 Mish1520 06 PPW C25

Uploaded by

Copyright:

Available Formats

Chapter 25

Chapter Preview (cont.)

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Financial Futures Markets

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Financial Futures Markets

Example: Hedging Interest Rate Risk

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Example: Hedging Interest Rate Risk

Financial Futures Markets

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Following the News

Widely Traded Financial

Copyright 2009 Pearson Prentice Hall. All rights reserved.

The manufacturer can use the FX futures

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Stock Index Futures

Stock Index Futures

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Hedging with Stock Index Futures

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Hedging with Stock Index Futures

To hedge $100 million of stocks that move

Hedging with Stock Index Futures

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

Either way, net position is $100 million

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Hedging with Stock Index Futures

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Options are available on a number of

if i decreases and price increases

Profit Profiles for Calls

Profit Profiles for Puts

Protective Put Profit

Covered Call Profit

Factors Affecting Premium

Hedging with Options

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Hedging with Options

To hedge $100 million of stocks that move

Hedging with Options

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Hedging with Options

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

Hedging with Options

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Mismatch in durations of Mutual

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Interest-Rate Swap Contract Example

Interest-Rate Swap Contract Example

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Hedging with Interest-Rate Swaps

Copyright 2009 Pearson Prentice Hall. All rights reserved.

Hedging with Interest-Rate Swaps

Financial intermediaries help reduce

Copyright 2009 Pearson Prentice Hall. All rights reserved.