CHAPTER26:DERIVATIVESANDHEDGING

RISK
TOPICS:
26.1
26.2
26.3
26.4
26.5

ForwardContracts
Futures
Hedging
InterestRateFuturesContracts
DurationHedging

Overview
Riskstobemanaged,andthemethodsusedtofinancethem.
Commoditypricerisk(futures)
Interestrateexposure(durationhedging/swaps)
FXexposure(derivatives)

Hedging
Findtwocloselyrelatedassets
Buyoneandselltheotherinproportionstominimizetherisk
ofyournetposition
Iftheassetsareperfectlycorrelated,yournetpositionisrisk
free

Howriskismanaged
Plant

May

Harvest
Sept.

Productioncosts:$1.50/bu
SellingpriceinSept.:Unknown
Whatcanthefarmerdotoreducerisk?
1.Donothing
2.BuyCropInsurance
3.Buyaputoption
4.EnteraForward/futurescontracttosell
3

26.1ForwardContracts
Aforwardcontractisanagreementtobuy/sellanassetata
particularfuturetimeforaspecifiedpricecalledthedelivery
price
Forwardcontractsarecustomizedandnotusuallytradedon
anexchange
Thelong(short)positionagreestobuy(sell)theassetonthe
specifieddateforthedeliveryprice
Whenthecontractisenteredinto,thedeliverypriceis
chosensothatthevalueofthecontractiszerotoeachparty.
theforwardpriceisthedeliverypricewhichmakesthe
contractvaluezero(sotheforwardpriceisequaltothe
deliverypriceattheinceptionofthecontract)
4

Examplesofaforward
Pizzaforwardcontract.
Orderpizzabyphone.Specifytopping(type),size,delivery
timeandlocationandpricefixedwhencontractis
established.Payondelivery.
Energyforward
Youbuy50,000cubicfeet(50Mcf)ofheatinggasinsummer
fromyourheatingcompanyfor$10perthousandcubicfeet
(Mcf),deliverablefromJan.March.
Longinforward:You
Short:HeatingCo.

PayoffsFromForwardContracts
letSTdenotethespotpriceoftheassetatthedeliverydateT
andletFtbethedeliveryprice(pricesetattpayableatT)
Thepayoffsonthedeliverydateare:
longpositionpayoff:STFt
shortpositionpayoff:FtST

Problemswithhedgingwithforwards
Hedgedwithforwardsisimperfect,sinceyoudonotknow
thequantityyouwillhavetotrade.
Thereiscreditriskwithforwardcontracts.
Bipartisanarrangement
Inthepreviousexample,ifheatinggaspriceincreasesharply
inthewinter,yourheatingcompanywilllose,anditmight
default.

26.2Futures
Verysimilartoforwardsinpayoffprofile,butaddresses
creditriskproblembymarkingtomarketeveryday.
Highlystandardizedcontracts(deliverylocation,contract
sizeetc.),whichpermitexchangetrading.
Thefuturespriceisanalogoustotheforwardprice:itisthe
deliverypriceforafuturescontract
thefuturespricewillconvergetothespotpriceofthe
underlyingassetwhenthecontractmatures

Moreinstitutionaldetails:
Theexactdeliverydateisusuallynotspecifiedinafuturescontract;rather
itissometimeintervalwithinthedeliverymonth
Actualdeliveryrarelyoccurs,insteadpartiescloseoutpositionsbytaking
offsettingtransactionspriortomaturity.Cashsettlement.
Therearecommoditiesfuturesandfinancialfutures(stocks,bondsand
currencies).
8

Example:CornFuturesatCBOT
Contract Size
5,000 bushels
Deliverable Grades
No. 2 Yellow at par, No. 1 yellow at 1 1/2 cents per bushel over contract
price, No. 3 yellow at 1 1/2 cents per bushel under contract price
Price Quote
Cents/bushel
Last Trading Day
The business day prior to the 15th calendar day of the contract month.
Last Delivery Day
Second business day following the last trading day of the delivery month.

Exp

Last

Net Open High Low Close ETS

Chg
Vol
06Dec 312'4 -3'2 316'0 319'0 311'4 312'4 37537
4DigitPriceQuote:Fourthdigitis1/8cent/bu

Futures/forwardpricecanchangeeveryday
Inoptions,Xdoesnotchange
Infutures,yourprofit/lossisbasedonfluctuationoffutures
price
Yourdailyprofit/lossforlongfuturesis:Newfuturesprice
thefuturespricethatyouagreed

Ifanoffsettingpositionistakenbeforetheexpiryforalong
futures,thenprofit/lossisFnewFt,whereFnewisthenew
futurespriceattheoffsettingtime.
Likewise,ifanoffsettingpositionistakenbeforetheexpiry
forashortfutures,thenprofit/lossisFtFnew.
10

Example
Consideraninvestorwhoentersafuturescontractexpiring
onemonthfromnowtopurchase100oz.ofgoldatthe
futurespriceof$275perounce.
Ifthespotpriceofgoldis$290ontheexpirydate,the
profit/lossis_____.
Iftheinvestorclosesoutherpositiontwoweekfromnowwith
afuturespriceof$280onthesamecontract.Thespotpriceis
$290.Herprofit/lossis______.

11

Markingtomarket/Margin
Profit/lossissettledeverydayonamarginaccount
Minimizedefaultrisk
Details
Initialmargin
Ifthevalueofthemarginaccountfallsbelowthe
maintenancemargin,thecontractholderreceivesa
margincall.
Youneedtoadd$tobringmarginbalancebackto
initialmarginlevel(otherwisecontractwillbeforced
tocloseout.)

12

Example:Markingtomarket
Consideraninvestorwhoentersafuturescontracttopurchase100oz.ofgold
atthefuturespriceof$875perounce.Supposethattheinitialmarginissetat
$6,000andthemaintenancemarginissetat$4,500.Thecontractisclosed
outafter6days.
Day

Futures
Price$

Cash
Flow$

Starting Cashaddedto
Margin$
Margin$

Ending
Margin$

875

6,000

6,000

872

869

874

875

1,100

7,100

1,100

6,000

884

900

6,900

6,900

(1)Whatistheprofitandlosstotheinvestor,e.g.atdays2and3?

(2)Whendoeshereceiveamargincall?Whattodowhenreceivingamargin
call?
(3)Whatshisultimategain/loss?

13

Futuresvs.Options
Similarities
Deferreddeliverymarkets
Limitednumberofcontracts
Standardizedcontracts
Exchangeismiddleman

Differences
Options
Longshaveright,not
obligationtobuy/sell
Frequentexercise

Futures
Bothlongsandshortshave
obligationtobuy/sell
Dailypricelimits
Markedtomarket
Deliveryseldomoccurs

14

HedgingwithfuturesLockinginprice
Therearetwotypesofinvestorswhousefutures/forward
Speculators:trytoprofitfrompricemovements
Hedgers:trytoprotectagainstpricemovementandtoreduce
riskbymakingoutcomelessvariable

Shorthedge(takeashortpositioninfutures)isusedwhen
youhaveassettosellinthefuture
Conversely,longhedge(takealongpositioninfutures)is
usedwhenyouhaveassettopurchaseinthefuture

15

ShortHedge
ConsiderafirmwhichwillbesellinganassetatsomefuturedateT,
andsupposethereisafuturescontractonthatassetfordeliveryatT
Thefirmisexposedtotheriskthatthepriceoftheassetmightfall
betweennowandT
Ifthefirmtakesashortpositioninafuturescontract,itsoverallpayoff
is:
futurespayoff
(FTF0)=(STF0)
payofffromsellingassetatT

ST

total

F0

i.e.thepriceofF0islockedintoday
Iftheassetpricefalls,thefirmlosesontheassetsalebutgainsonthe
futurescontract
Iftheassetpricerises,thefirmgainsonthesalebutlosesonthefutures
contract
16

Example:Shorthedge
ItisNovember2003.Thecanolafarmerisworriedaboutthepriceofhis
crop(output).Hesellscanolafutures;say50tonnesFeb2004at$300
pertonne.InFebruary2004,whenthefarmerharvestshiscrop,the
marketpriceofcanolais$250pertonne.
Thefarmer'sprofitsfromfutures=_____________pertonne
Thefarmer'sproceedsfromsaleofcanola=___________pertonne
Total=_______pertonne

SupposeinFebruary2004,whenthefarmerharvestshiscrop,the
marketpriceofcanolais$450pertonne.
Thefarmer'sprofitsfromfutures=_____________pertonne
Thefarmer'sproceedsfromsaleofcanola=___________pertonne
Total=___________pertonne
17

LongHedge
SupposeinsteadafirmwantstopurchaseanassetatsomefuturedateT
Thefirmisexposedtotheriskthatthepriceoftheassetmightrise
betweennowandT
Ifthefirmtakesalongpositioninafuturescontract,itsoverallpayoffis:
futurespayoff
FTF0=STF0
paymentfrompurchasingassetatT ST
totalF0
i.e.thepriceofF0islockedintoday
iftheassetpricefalls,thefirmgainsontheassetpurchasebutloseson
thefuturescontract
Andviceversa

Notethatfutureshedgingdoesnotnecessarilyimprovetheoverall
outcome:youcanexpecttoloseonthefuturescontractroughlyhalfof
thetime=>theobjectiveofhedgingistoreduceriskbymakingthe
outcomelessvariable
18

InterestRateFuturesContracts
Futurescontractwhoseunderlyingsecurityisadebt
obligation.

Wellconsiderinterestratefutures
Interestratefuturesareusedtolockintotheforwardterm
structure(lockintofutureinterestrates).

19

TermStructureofInterestRates
ThetextcoverageofthismaterialisinAppendix6A
Althoughinalmostallcasesinthiscourseweconsideraflatterm
structure(interestratesofdifferentmaturities),itisimportanttokeep
inmindthatthisisasimplification
Withaflattermstructure,discountratesarethesameforallmaturities,
butthisisrarely(ifever)thecase
ForOct.31,2007,theBankofCanadareportedgovernmentzero
coupongovernmentbondyieldsasfollows:
Maturity1yr3yr5yr7yr10yr15yr
Yield 4.184.164.184.214.284.37
Thismeans,forexample,thatthepriceonOct.31ofaoneyearzero
coupongovernmentbondpaying$1,000atmaturitywas$1,000/1.0418=
$959.88,whilethepriceofatenyearzerocoupongovernmentbond
paying$1,000atmaturitywas$1,000/1.042810=$657.64
Theratesabove,whichcanbeusedtodeterminepricesatwhichbonds
maybecurrentlytraded,areknownasspotrates
20

PricingofGovernmentBonds
ConsideraGovernmentofCanadabondthatpaysasemi
annualcouponof$CforthenextT/2years(Notethatthere
isatotalofT=2(T/2)payments):

C
0

C
2

CF
T

C
C
C
CF
PV

2
3
(1 r1 ) (1 r2 ) (1 r3 )
(1 rT )T
Ifthetermstructureisflat,i.e.r1=r2==rT=r,thenthe
aboveformulasimplifiestothefamiliarCATr+F/(1+r)T
21

PricingofInterestRateForwardContracts
AnNperiodforwardcontractonthatGovernmentBond
Pforward C

N+1 N+2 N+3

CF

N+T

Can be valued as the present value of the forward price:

PV

Pforward
(1 rN ) N

C
C
C
CF

N 1
N 2
N 3
(1 rN 1 )
(1 rN 2 )
(1 rN 3 )
(1 rN T ) N T
Intheabove,PVisthecurrentvalueoftheforwardcontract.
Pforwardistheforwardcontractprice(thepriceyoullpayinthe
future).Oneimpliestheother.

22

Example
Considera5yearforwardcontractona20year
GovernmentofCanadabond.Thecouponrateis6percent
perannumandpaymentsaremadesemiannuallyonapar
valueof$1,000.Thequotedyieldtomaturityis5%.
Assumethatthetermstructureisflat.Whatisthevalueof
thebondtoday?Whatistheforwardprice?

23

Interestratefuturescontractsandhedging
Inpractice,futurescontractsonbondsaretypicallyused
ratherthanforwardcontracts
Futurescontractsonbondsarereferredtoasinterestrate
futurescontracts
Thepricingrelationshipsderivedaboveforforward
contractswillonlybeanapproximationinthiscontext
Theexactdeliverydateisdeterminedbytheshortpartyina
futurescontract

24

2 Year U.S. Treasury Notes

Futures, CBOT
Exp

Last 1
Last 2

Net
Chg

Open

High

Low

Close

Settle Prev
Settle

07Dec 103'275

- 103'287 103'302 103'265 103'275

9:20 0'027
18:01
8:36
6:40
9:20
Table generated October 25, 2007 09:21 CDT

Hi/Lo ETS
Limit Vol

103'302
= Chart

116084
= Option

Contract Size
One CBOT U.S. Treasury note having a face value at maturity of $200,000 or
multiple thereof.
Deliverable Grades
U.S. Treasury notes that have an original maturity of not more than 5 years and 3
months and a remaining maturity of not less than 1 year and 9 months from the
first day of the delivery month but not more than 2 years from the last day of the
delivery month. The invoice price equals the futures settlement price times a
conversion factor plus accrued interest. The conversion factor is the price of the
delivered note ($1 par value) to yield 6 percent.
Price Quote
Points ($2,000) and one quarter of 1/32 of a point; for example, 91-16 equals 91
16/32 ,84165equals8416.5/32
25

Useinterestratefuturestolockintofutureinterestrate
Example:Youown$10millionworthof20year10%couponbond
(semiannualcouponpayments).Thetermstructureisflatat5%(semi
annual).Thesebondsarethereforesellingat$1,000.
40

50

t 11.05

1,000
1.05

$1,000

40

Ifthetermstructureshiftsupuniformlyto5.5%,thenewpriceperbondis:
40

50

t 11.055

1,000
1.055

40

$919.77

Sinceyouhave10,000ofthesebonds,youhavelost

Youwanttolockintotheinterestratestopreventtheloss.Whatshould
youdo?
26

Examplecontd:Oppositepositioninfutures
Supposegovernmentbondfuturescontractspecifies6monthdeliveryof
$100,000parvalueof20year8%couponbond.Thecurrentprice(value)for
thisfuturescontractis:
Afterthetermstructureshift,itis:
Eachshortfuturescontractgains
SupposeyouhedgebyshortingKfuturescontracts:
K=Sizeofexposure/sizeoffuturescontract
Gainonfutures=
Overall:Approximatelyyoulockintothe5%interestrate.

27

Reasonsinpracticewhyinteresthedgingusingfutures
maynotworkperfectly
Differentmaturities(bondsinportfoliovs.futurescontract)
Differentcouponrates
Differentrisk(e.g.corporatebondsinportfolio,government
bondsinfuturescontract)

28

Interestraterisk
Interestrateriskimpactofchangingmarketyieldson
price
Assumeforsimplicityaflattermstructure.Considerthese
fourbonds,eachwith$1,000parvalueandcouponspaid
annually:

Note:percentagepricechangesarecalculatedrelativetothe
pricewhenr=10%,e.g.(877.93875.66)/875.66=
+.2592%.
29

Interestrateriskcontd
Observationsfromthepreviousslide
ComparingA,B,andC:lowcouponbondpricesaremore
sensitive(i.e.higherpercentagepricechange)tochangesinr,
giventhesameT
ComparingCandD:longermaturitybondpricesaremore
sensitivetochangesinr,giventhesamecoupon

Rankbondsbytheirinterestraterisk:
Bond

Coupon (%)

A
B
C

9
10
4

Maturity
(Years)
8
7
6
30

Duration
Howdowemeasurethesensitivityofbondpricesto
changesininterestrates?

Thismeansthatthepercentagechangeinpriceforagiven
changeinris:

31

Durationcontd
Durationisdefinedas:

Or:

CFt /( 1 r )t
Wt
Bond Pr ice

CFt=cashflowatt

D tWt
t 1

Durationmeasureshowlong,onaverage,abondholdermust
waittoreceivecashpayments(ameasureoftheeffective
maturityofthebondgivenwhenitscashflowsoccur)
32

Example
Calculatethedurationfora3yearbond,P=1,026.25,8%annual
coupon,r=7%
1

80

80

1,080

PV of cash Flow

74.77

69.88

881.60

Relative value (Wt)

0.0729

0.0681

.8591

Payment or cash flow

Weighted maturity (tWt)

Duration=
33

DurationandInterestRateRisk
Abitofalgebrayields:

dP
1

D dr
P
1 r
Durationmeasuresthesensitivityofbondpricestochanges
ininterestrates
Itisthefirstorderapproximationofpricesensitivitytointerestrate
Forasmallchangeininterestrate,durationisquiteanaccurate
estimateforpercentpricechange

Foragivenchangeinyield,thelargerabond'sdurationthegreater
theimpactonprice(interestraterisk/sensitivity)
34

Example
Whichbondhasthehigherduration(treateachcolumn
separately,assumeeverythingelsebeingequal)?
Bond

Coupon

Maturity

Yield

10%

10years

10%

5%

5years

5%

35

PortfolioDuration
ThedurationofaportfolioPcontainingMbondsis:
M

DP wi Di
i 1

wherewiisthepercentageweightofbondiinP.

36

Examples
D=3.3,P=1,000,r=10%,ifrdropsto9%,whatisthe
pricechangeasmeasuredbyduration?

Portfolioduration
Abondmutualfundholdsthefollowingtwozerocouponbonds:
(1)5yearmaturityand5%yieldwith40%ofportfolio
investment;(2)10yearmaturityand6%yieldwith60%portfolio
investment.Whatsthedurationforthefundsportfolio?

37

ImmunizationBalancesheethedgingbasedonduration
Immunizationisahedgingstrategybasedonduration
designedtoprotectagainstinterestraterisk.

Matchthevaluechangesinbothsidesofbalancesheet:
Thedropinthevalueofassetscanbe(partially)offsetbythe
dropinthevalueofliabilities.

Immunizationisaccomplishedbyequatingtheinterestrate
exposureofassetsandliabilities
AssetDurationassets=LiabilityDurationliabilities

38

Example
Youhavejustlearnedthatyourfirmhasafutureliabilityof$1million
dueattheendoftwoyears.Supposetherearetwodifferentbonds
availableandr=10%.
Durationofliability=2years
Bond1:7%annualcoupon,T=1year,$1,000parvalue;
P1=
Duration(D1)=1year
Bond2:8%annualcoupon,T=3years,$1,000parvalue
P2=
duration(D2)=2.78yearsaftersomecalculation
39

Examplecontd:Immunizationstrategies

If:
Buybond1andthenanother1yearbondafterayearruns
riskoflowerratesavailableforsecondyearreinvestmentrisk
Buybond2andsellafter2yearsIfratesrisebeforethen,
bondpricesfall,soinvestmentmaynotbeenoughtocover
liabilitypricerisk

Investinacombinationofbonds1and2sothattheexposure
tointerestrateriskwillbethesamebetweenassets(your
investment)andliability
Basicidea:ifratesrise,theportfolioslossesonthe3year
bondswillbeoffsetbygainsonreinvested1yearbonds.
Andviceversa.
Howmuchshouldyouinvestineachbond?
40

Examplecontd:solution
w1%investedin1yearbondsand(1w 1)%in3yearbonds.
w1*D1+(1w1)D2=
Totalamounttobeinvested=
Amountin1yearbonds=
Numberof1yearbonds=
Amountin3yearbonds=
Numberof3yearbonds=
41

Examplecontd:Doestheimmunizationstrategywork?
rafter1year
9%

10%

11%

$438,197

$442,181

Valueatt=2of3yearbonds:
Valuefromreinvestingcouponsreceivedatt=1

$42,997

$43,388

Couponsreceivedatt=2;

$39,088

$39,088

Sellingpriceatt=2;

$479,716

$475,395

Total

$999,998 $1,000,052

Valueatt=2fromreinvesting1yearbond
proceeds:

42

Immunizationcontd
Ascanbeseenfromthetableabove,theimmunizationstrategyappears
toperformfairlywell
However,thereareanumberofassumptionsneededforthistowork.
Somepossibleproblemsinclude:
thestrategyassumesthatthereisnodefaultriskorcallriskforthebonds
intheportfolio
Thestrategyassumesthatthetermstructureisflatandanyshiftsinitare
parallel
durationwillchangeovertime(evenifrdoesnot),sothemanagermay
havetorebalancetheportfolio(notethatthereisatradeoffofaccuracy
fromfrequentrebalancingvs.transactionscosts)

Morecomplicatedstrategiesexisttohandlethesetypesofproblems,but
immunizationusingdurationisstillaverywidelyusedtoolinpractice

43

Assignedquestions#26.15,79,1214,17

44