CH25

CHAPTER 25 : CHAPTER 25 HEDGING FINANCIAL RISK


HEDGING FINANCAL RISK : HEDGING FINANCAL RISK COMPANIES CAN STRUCTURE BUSINESS TO REDUCE RISK BUILD FLEXIBILITY INTO OPERATIONS COMPANY THAT USES STANDARDIZED MACHINES RATHER THAN SPECIALIZED EQUIPMENT LOWERS COST OF BAILING OUT COMPANIES CAN ALSO ENTER INTO FINANCIAL CONTRACTS TO HEDGE (OFFSET) RISK WHY SHOULD A COMPANY HEDGE? AT BEST, ZERO-NPV TRANSACTION MAKES FINANCIAL PLANNING EASIER UNHEDGED SETBACK CAN LEAD TO FINANCIAL DISTRESS


WHY SHOULD A COMPANY HEDGE? : WHY SHOULD A COMPANY HEDGE? ALLOWS SEPARATION OF MANAGEMENT CONTRIBUTION FROM EFFECT OF EXTERNAL FACTORS, SUCH AS: CHANGES IN INTEREST RATES COCOA PRICES FOCUSES MANAGEMENT’S ATTENTION ON BUSINESS ISSUES IT CAN INFLUENCE TREASURY DEPARTMENT OF MANY LARGE FIRMS ASSUMES RISK EXPOSURES OF A BUSINESS BY PROVIDING “INTERNAL HEDGES” AT MARKET PRICES TREASURER MAKES SEPARATE DECISION ON WHETHER TO HEDGE FIRM’S EXPOSURE


WHY SHOULD A COMPANY HEDGE? : WHY SHOULD A COMPANY HEDGE? MANY BUSINESSES INVOLVE PACKAGE OF BETS IF PORSCHE DECIDES TO LAUNCH NEW MODEL AIMED AT AMERICAN MARKET ONE BET IS ON $/DM EXCHANGE RATE IF PORSCHE IS PESSIMISTIC ON EXCHANGE RATES BUT OPTIMISTIC ON EVERYTHING ELSE GO AHEAD BUT HEDGE EXCHANGE RATE BET


INSURANCE : INSURANCE BUSINESSES BUY INSURANCE TO REDUCE RISK RISK PLANT WILL BURN DOWN RISK SHIP WILL BE INVOLVED IN ACCIDENT TRANSFERRING RISK TO INSURANCE COMPANY


INSURANCE : INSURANCE INSURANCE COMPANIES HAVE ADVANTAGES IN BEARING RISK CAN MORE ACCURATELY ESTIMATE PROBABILITY OF LOSS SKILLED AT GIVING ADVICE ON REDUCING RISK AND MAY OFFER REDUCED PREMIUMS TO FIRMS TAKING THE ADVICE POOLING OF RISK CLAIMS ON ANY INDIVIDUAL POLICY MAY BE HIGHLY UNCERTAIN CLAIMS ON PORTFOLIO OF POLICIES VERY STABLE


INSURANCE : INSURANCE FIRMS USE INSURANCE POLICIES TO REDUCE SPECIFIC RISK INSURANCE COMPANIES CANNOT DIVERSIFY AWAY MACROECONOMIC RISK FIRMS MUST FIND OTHER WAYS TO MANAGE MACRO RISKS


DISADVANTAGES OF INSURANCE : DISADVANTAGES OF INSURANCE ADMINISTRATIVE COSTS ARRANGING AND HANDLING CLAIMS ADVERSE SELECTION BAD RISKS WILL BE MOST EAGER TO TAKE OUT INSURANCE PREMIUMS REFLECT THAT MORAL HAZARD AN INSURED MAY BEHAVE DIFFERENTLY KNOWING THAT THEY WILL NOT BEAR THE FINANCIAL CONSEQUENCES OF THEIR ACTIONS


INSURANCE : INSURANCE COMPANIES TYPICALLY BUY INSURANCE AGAINST LARGE POTENTIAL LOSSES UNPREDICTABLE CAN TRIGGER FINANCIAL DISTRESS SELF INSURE AGAINST SMALL POTENTIAL LOSSES BP HAS CHALLENGED THIS CONVENTIONAL WISDOM DURING 1980s PAID OUT AVERAGE OF $115MM PER YEAR IN PREMIUMS RECOVERED $25MM A YEAR IN CLAIMS


BP INSURANCE POLICY : BP INSURANCE POLICY BP WILL NOW ALLOW LOCAL MANAGERS TO INSURE AGAINST RELATIVELY ROUTINE RISKS INSURANCE COMPANIES HAVE ADVANTAGE OF ASSESSING RISK AND COMPETE VIGOROUSLY WILL NOT GENERALLY INSURE AGAINST EXTERNAL RISKS ABOVE $10MM LARGER, MORE SPECIALIZED RISKS INSURANCE COMPANIES HAVE LESS ABILITY TO ASSESS RISKS NOT COMPETITIVELY PRICED BP ESTIMATED ITS NEW POLICY EXPOSED IT TO LOSSES AS LARGE AS $500MM ONCE IN 30 YEARS 1% OF BP EQUITY AFTER TAX FOR LARGE, LOW PROBABILITY RISKS, STOCK MARKET MORE EFFICIENT RISK-ABSORBER THAN INSURANCE COMPANY


HOME-MADE INSURANCE : HOME-MADE INSURANCE INVESTMENT DEALER HAS INVENTORY OF IBM STOCK INSURE AGAINST LOSS BY BUYING PUT $90 STRIKE U.S. CONSTRUCTION COMPANY BIDDING ON CONSTRUCTION CONTRACT IN FRANCE U.S. DOLLAR COSTS BY TIME CONTRACT AWARDED FF/$ EXCHANGE RATE MAY CHANGE AFFECT PROFITABILITY OF PROJECT BUY OPTION TO SELL FF INSURANCE PREMIUM IS OPTION PRICE


HOME-MADE INSURANCE : HOME-MADE INSURANCE IF YOU GET CONTRACT AND FF WEAKENS PROCEEDS ON EXERCISE OF OPTION WILL OFFSET REDUCTION IN VALUE OF CONTRACT IN DOLLARS IF YOU DON’T GET CONTRACT HAVE OPTION WHICH WILL BE PROFITABLE IF FRANC DEPRECIATES AND WORTHLESS OTHERWISE


HEDGING WITH FUTURES : HEDGING WITH FUTURES HEDGING TAKING ON ONE RISK TO OFFSET ANOTHER HEDGING INSTRUMENTS FUTURES FORWARDS SWAPS OPTIONS DERIVATIVES VALUE DEPENDS ON VALUE OF ANOTHER ASSET


FUTURES CONTRACTS : FUTURES CONTRACTS OLDEST TRADED DERIVATIVE DEVELOPED FOR AGRICULTURAL AND OTHER COMMODITIES SPOT PRICE PRICE OF WHEAT FOR IMMEDIATE DELIVERY


EXAMPLE : EXAMPLE FARMER WILL HAVE 100,000 BUSHELS OF WHEAT IN SEPTEMBER HEDGE BY SELLING 100,000 BUSHELS OF SEPTEMBER WHEAT FUTURES AGREES TO DELIVER 100,000 BUSHELS OF WHEAT IN SEPTEMBER AT PRICE SET TODAY FIRM UNDERTAKING, NOT OPTION


FUTURES CONTRACTS : FUTURES CONTRACTS MILLER IN OPPOSITE SITUATION NEEDS TO BUY WHEAT IN SEPTEMBER WANTS TO FIX PRICE TODAY BUYS WHEAT FUTURES AGREES TO TAKE DELIVERY OF WHEAT IN SEPTEMBER AT PRICE FIXED TODAY


FUTURES CONTRACTS : FUTURES CONTRACTS BOTH FARMER AND MILLER HAVE LESS RISK FARMER SELLS WHEAT FUTURES - SHORT HEDGE MILLER BUYS WHEAT FUTURES - LONG HEDGE


FUTURES CONTRACTS : FUTURES CONTRACTS FARMER MAY DECIDE TO WAIT UNTIL CONTRACT EXPIRES DELIVER WHEAT TO BUYER IN PRACTICE DELIVERY IS RARE MORE CONVENIENT FOR FARMER TO BUY BACK CONTRACT JUST BEFORE MATURITY ANY LOSS ON SALE EXACTLY OFFSET BY PROFIT ON FUTURES CONTRACT FUTURES CONTRACTS TRADED ON ORGANIZED FUTURES EXCHANGES LIST OF PRINCIPAL COMMODITY FUTURES CONTRACTS AND EXCHANGES ON WHICH THEY TRADE


SOME FUTURES CONTRACTS : SOME FUTURES CONTRACTS Commodity Futures Soybean oil - CBT Wheat - CBT Cattle - CME Coffee - CSCE Gold - COMEX Copper - LME Crude Oil - NYMEX Gas, Oil - IPE Financial Futures US T Bills - CME US T bonds - CBT Eurodollars - CME S&P Index - CME Notionnel - Matif Bund - Liffe, DTB Long gilt - Liffe


ABBREVIATIONS : ABBREVIATIONS CBT CHICAGO BOARD OF TRADE CME CHICAGO MERCANTILE EXCHANGE COMEX COMMODITY EXCHANGE, NEW YORK CSCE COFFEE, SUGAR AND COCOA EXCHANGE, NEW YORK IPE INTERNATIONAL PETROLEUM EXCHANGE OF LONDON LME LONDON METAL EXCHANGE NYMEX NEW YORK MERCANTILE EXCHANGE


FINANCIAL FUTURES : FINANCIAL FUTURES FLUCTUATIONS IN INTEREST RATES AND EXCHANGE RATES IMPORTANT SOURCE OF RISK TO MANY FIRMS HEDGED WITH FINANCIAL FUTURES SIMILAR TO COMMODITY FUTURES BUT CONTRACT TO BUY OR SELL A FINANCIAL ASSET AT A FUTURE DATE AT SET PRICE INVENTED IN 1972 WITHIN FEW YEARS, TRADING IN FINANCIAL FUTURES EXCEEDED TRADING IN COMMODITY FUTURES


MECHANICS OF FUTURES TRADING : MECHANICS OF FUTURES TRADING WHEN YOU BUY FUTURES CONTRACT PRICE FIXED TODAY PAYMENT NOT MADE UNTIL LATER REQUIRED TO PUT UP MARGIN FUTURES CONTRACTS MARKED TO MARKET EVERY DAY CALCULATE DAILY PROFIT AND LOSS ON CONTRACT PAY EXCHANGE ANY LOSSES, RECEIVE ANY PROFITS


MECHANICS OF FUTURES TRADING : MECHANICS OF FUTURES TRADING EXAMPLE: FARMER AGREED TO DELIVER 100,000 BUSHELS OF WHEAT AT $2.50 PER BUSHEL NEXT DAY PRICE OF WHEAT FUTURES DECLINES TO $2.45 A BUSHEL FARMER HAS PROFIT OF 100,000 x $.05 = $5,000 EXCHANGE’S CLEARINGHOUSE PAYS $5,000 TO FARMER AS IF FARMER IS CLOSING OUT HIS POSITION EVERY DAY AND OPENING A NEW POSITION FARMER NOW HAS OBLIGATION TO DELIVER WHEAT FOR $2.45 A BUSHEL $2.45 A BUSHEL STILL TO BE PAID + 5 CENTS ALREADY PAID = ORIGINAL $2.50 SELLING PRICE


MECHANICS OF FUTURES TRADING : MECHANICS OF FUTURES TRADING MILLER IN OPPOSITE SITUATION FALL IN FUTURES PRICE LEAVES HER WITH LOSS OF 5 CENTS A BUSHEL PAYS THIS LOSS TO EXCHANGE MILLER CLOSES OUT HER INITIAL PURCHASE AT 5 CENT LOSS AND OPENS A NEW CONTRACT TO TAKE DELIVERY AT $2.45 A BUSHEL $2.45 A BUSHEL STILL TO BE PAID + 5 CENTS ALREADY PAID = ORIGINAL $2.50 PURCHASE PRICE


SPOT AND FUTURES PRICES : SPOT AND FUTURES PRICES BUY A SECURITY FOR IMMEDIATE DELIVERY AT SPOT PRICE OR BUY IT FOR LATER DELIVERY AT FUTURES PRICE END UP WITH SAME SECURITY YOU COULD HAVE BOUGHT IN SPOT MARKET BUT NOW YOU ONLY PAY FOR IT AT DELIVERY MISS OUT ON DIVIDENDS OR INTEREST FUTURES PRICE/(1 + rf)t = SPOT PRICE - PV(FOREGONE DIVIDENDS OR INTEREST) rf t - PERIOD RISK - FREE INTEREST RATE IGNORES MARK TO MARKET OF FUTURES CONTRACT


EXAMPLE : EXAMPLE WHAT IS A FAIR PRICE FOR 6-MONTH STOCK INDEX FUTURES? INDEX = 464 6-MONTH INTEREST RATE = 7% PER YEAR AVERAGE DIVIDEND YIELD = 2.7% PER YEAR FUTURES PRICE/(1 + rf)t = SPOT PRICE - PV(FOREGONE DIVIDENDS OR INTEREST) FUTURES PRICE/(1.035) = 464 - (464 x .0135/1.035) FUTURES PRICE = 473.98


SPOT AND FUTURES PRICES - COMMODITIES : SPOT AND FUTURES PRICES - COMMODITIES DIFFERENCE BETWEEN BUYING COMMODITIES TODAY AND BUYING COMMODITY FUTURES MORE COMPLICATED BUYER OF COMMODITY FUTURES DELAYS PAYMENT SAVES STORAGE COSTS (WAREHOUSE, WASTAGE) - MISSES OUT ON CONVENIENCE YIELD VALUE OF BEING ABLE TO GET YOUR HANDS ON REAL THING TRY STOCKING YOUR SHELF WITH ORANGE JUICE FUTURES IF YOU RUN OUT OF INVENTORY!


SPOT AND FUTURES PRICES - COMMODITIES : SPOT AND FUTURES PRICES - COMMODITIES FUTURES PRICE/(1 + rf)t = SPOT PRICE + PV(STORAGE COSTS) - PV(CONVENIENCE YIELD) NET CONVENIENCE YIELD = PV(CONVENIENCE YIELD) - PV(STORAGE COSTS) INFER NET CONVENIENCE YIELD BY COMPARING SPOT PRICE WITH DISCOUNTED FUTURES PRICE


EXAMPLE : EXAMPLE AS OF JUNE 1995 SPOT PRICE HEATING OIL $.47 PER GALLON FUTURES PRICE FOR JUNE 1996 $.475 PER GALLON 1-YEAR RISK-FREE RATE 5.7% PV(FUTURES PRICE) .475/1.057 = .45 PV(NET CONVENIENCE YIELD) = SPOT PRICE - FUTURES PRICE/(1 + rf)t = .47 - .45 = .02


SPOT AND FUTURES PRICES - COMMODITIES : SPOT AND FUTURES PRICES - COMMODITIES NET CONVENIENCE YIELD SOMETIMES EXPRESSED AS PERCENTAGE OF SPOT .02/.47 = 4.3% EVIDENCE THAT NET CONVENIENCE YIELDS RELATED TO LEVEL OF INVENTORIES


FORWARD CONTRACTS : FORWARD CONTRACTS FUTURES CONTRACTS VERY LIQUID STANDARDIZED MATURE ON LIMITED NUMBER OF DATES TERMS OF FUTURES CONTRACTS MAY NOT MEET YOUR PARTICULAR NEEDS BUY OR SELL FORWARD CONTRACT TAILOR-MADE FUTURES CONTRACT MAIN FORWARD MARKET FOREIGN CURRENCY BANKS QUOTE PRICES AT WHICH THEY WILL BUY OR SELL FOREIGN CURRENCY FOR UP TO 5 YEARS


FORWARD CONTRACTS : FORWARD CONTRACTS ALSO FORWARD INTEREST-RATE CONTRACTS EXAMPLE: AT END OF 6 MONTHS YOU WILL NEED 3-MONTH LIBOR BASED LOAN LOCK IN INTEREST RATE BUY FORWARD RATE AGREEMENT (FRA) FROM BANK “BUY 6 AGAINST 9 MONTHS” MONEY FRA IS FOR 3-MONTH LOAN IN 6 MONTH’S TIME BANK MIGHT SELL 6-MONTH FRA ON 3-MONTH LIBOR AT 7% IF 3-MONTH LIBOR IS GREATER THAN 7% AT END OF 6 MONTHS BANK WILL PAY YOU DIFFERENCE AND VICE-VERSA


FORWARD CONTRACTS : FORWARD CONTRACTS AT END OF 1992 OUTSTANDING FOREIGN CURRENCY FORWARD CONTRACTS $5.5 TRILLION OUTSTANDING FRA’s $2 TRILLION


HOME-MADE FORWARD CONTRACTS : HOME-MADE FORWARD CONTRACTS BORROW $90.91 FOR 1 YEAR AT 10% LEND $90.91 FOR 2 YEARS AT 12% CASH FLOWS YEAR 1 YEAR 2 YEAR 3 BORROW FOR 1 YEAR AT 10% +90.91 -100 LEND FOR 2 YEARS AT 12% -90.91 +114.04 NET CASH FLOW 0 -100 +114.04 NO NET CASH OUTFLOW TODAY CONTRACTED TO LEND MONEY IN YEAR 1 INTEREST RATE ON THIS FORWARD COMMITMENT = 14.04%


HOME-MADE FORWARD CONTRACTS : HOME-MADE FORWARD CONTRACTS FORWARD INTEREST RATE = [(1 + 2-YEAR SPOT RATE)2/(1 + 1-YEAR SPOT RATE)] - 1 = 1.122/1.10 - 1 = .1404 = 14.04% WE REPLICATED A FORWARD LOAN BY BORROWING SHORT-TERM AND LENDING LONG CAN REVERSE PROCESS FIX RATE AT WHICH YOU BORROW NEXT YEAR BORROW LONG AND LEND MONEY UNTIL YOU NEED IT NEXT YEAR


HOME-MADE FORWARD CONTRACTS : HOME-MADE FORWARD CONTRACTS YOU CAN ALSO CONSTRUCT DO-IT-YOURSELF CONTRACT TO BUY OR SELL FOREIGN EXCHANGE EXAMPLE: YOU WANT TO PLACE AN ORDER TO BUY SWISS FRANCS IN 1 YEAR SPOT RATE 2 SF/$ 1-YEAR DOLLAR INTEREST RATE = 6% 1-YEAR SF INTEREST RATE = 4% BORROW $50 FOR ONE YEAR EXCHANGE DOLLARS INTO FRANCS AND LEND FRANCS FOR 1 YEAR


HOME-MADE FORWARD CONTRACTS : HOME-MADE FORWARD CONTRACTS CASH FLOWS NOW AFTER 1 YEAR $ SF $ SF BORROW $ AT 6% +50 -53 CHANGE $ INTO SF -50 +100 LEND SF AT 4% -100 +104 NET CASH FLOW 0 0 -53 +104 NET CASH FLOW TODAY = 0 COMMITTED TO LEND $53 AT END OF YEAR AND RECEIVE SF104 YOU HAVE CONSTRUCTED FORWARD CONTRACT TO BUY SF AT 104/53 = 1.96SF/$


HOME-MADE FORWARD CONTRACTS : HOME-MADE FORWARD CONTRACTS FAIR PRICE FOR FORWARD (OR FUTURES) CONTRACT FORWARD PRICE = SPOT PRICE x 1+ FRANC INTEREST RATE 1 + DOLLAR INTEREST RATE = (100/50) x (104/106) = 1.96 SF/$ WHAT WOULD HAPPEN IF FUTURES PRICE HIGHER, SAY 2SF/$? EVERYONE WOULD SELL FUTURES BORROW DOLLARS AND LEND FRANCS RISKLESS ARBITRAGE


HOME-MADE FORWARD CONTRACTS : HOME-MADE FORWARD CONTRACTS IF YOU CAN MAKE YOUR OWN FORWARD CONTRACTS FOR INTEREST RATES OR CURRENCIES WHY TRADE FINANCIAL FUTURES? CONVENIENCE AND COST


SWAPS : SWAPS POSSUM WANTS TO BORROW 5-YEAR DM TO FINANCE ITS EUROPEAN OPERATIONS BETTER KNOWN IN U.S. OBTAINS BETTER TERMS ON $ LOAN BORROWS $10MM 5-YEAR 12% NOTES IN US ARRANGES FOR A BANK TO PAY COMPANY DOLLARS REQUIRED TO SERVICE $ LOAN IN EXCHANGE, COMPANY WILL MAKE ANNUAL DM PAYMENTS TO BANK COMPANY HAS SWAPPED FUTURE DOLLAR LIABILITY FOR DM COMPANY AND BANK ARE COUNTERPARTIES


POSSUM’S CASH FLOWS : POSSUM’S CASH FLOWS YEAR 0 YEARS 1-4 YEAR 5 $ DM $ DM $ DM 1. ISSUE DOLLAR LOAN +10 -1.2 -11.2 2. SWAP $ FOR DM -10 +20 +1.2 -1.6 +11.2 -21.6 3. NET CASH FLOW 0 +20 0 -1.6 0 -21.6


POSSUM : POSSUM NET EFFECT CONVERT 12% DOLLAR LOAN INTO 8% DM LOAN CASH FLOWS SERIES OF FORWARD CONTRACTS IN YEARS 1 - 4, POSSUM AGREES TO PURCHASE $1.2MM AT COST OF 1.6MM DM IN YEAR 5, POSSUM AGREES TO PURCHASE $11.2MM AT COST OF 21.6MM DM CURRENCY SWAP


COUNTERPARTY’S POSITION : COUNTERPARTY’S POSITION BANK’S CASH FLOWS REVERSE OF POSSUM’S COMMITTED TO PAY OUT DOLLARS IN FUTURE AND RECEIVE DM EXPOSED TO FUTURE WEAKENING OF DM HEDGES ITS RISK BY SERIES OF FUTURES OR FORWARD CONRACTS SWAPPING DM FOR DOLLARS WITH ANOTHER COUNTERPARTY


INTEREST-RATE SWAP : INTEREST-RATE SWAP COUNTERPARTIES SWAP FIXED ANNUAL PAYMENTS FOR SERIES OF PAYMENTS TIED TO LEVEL OF SHORT-TERM INTEREST RATES SOMETIMES COUNTERPARTIES SWAP SERIES OF PAYMENTS LINKED TO DIFFERENT BASE RATES ONE FIRM MIGHT SWAP SERIES OF PAYMENTS TIED TO PRIME RATE FOR SERIES OF PAYMENTS TIED TO T-BILLS


CADBURY SCHWEPPES : CADBURY SCHWEPPES EXAMPLE OF COMPANY THAT USES BOTH CURRENCY SWAPS AND INTEREST RATE SWAPS ACTIVE COMMERCIAL PAPER PROGRAM ESTIMATED 30 BP INTEREST-RATE SAVING SWAPS VARIABLE-RATE US$ FOR FIXED OTHER CURRENCIES


COMMODITY SWAPS : COMMODITY SWAPS DON’T HAVE TO DELIVER COMMODITIES SETTLE DIFFERENCES IN VALUE CSG COULD EFFECTIVELY LOCK IN PRICE AT WHICH IT BUYS SUGAR BY SWAPPING A FIXED CASH FLOW FOR A CASH FLOW TIED TO SUGAR PRICES


FRIENDLY BANK : FRIENDLY BANK HOME-MADE FIXED-TO-FLOATING INTEREST-RATE SWAP FRIENDLY BANK HAS MADE 5-YEAR $50MM LOAN AT FIXED INTEREST-RATE OF 8% RECEIVES $4MM INTEREST EACH YEAR AND $50MM PRINCIPAL WILL BE REPAID AT YEAR 5 BANK WANTS TO SWAP $4MM 5-YEAR FIXED ANNUITY INTO FLOATING-RATE ANNUITY BANK CAN BORROW AT 6% FIXED FOR 5 YEARS $4MM IT RECEIVES CAN SUPPORT FIXED RATE LOAN OF 4/.06 = $66.7MM NOTIONAL PRINCIPAL AMOUNT OF THE SWAP


FRIENDLY BANK : FRIENDLY BANK BANK COULD CONSTRUCT HOME-MADE SWAP AS FOLLOWS: BORROWS $66.7MM AT 6% FIXED FOR 5-YEARS AND LENDS SAME AMOUNT AT LIBOR CURRENTLY AT 5%


FRIENDLY BANK : FRIENDLY BANK NO CASH FLOW AT START AT YEAR 5, PRINCIPAL AMOUNT OF SHORT-TERM INVESTMENT USED TO PAY OFF $66.7MM LOAN REMAINING CASH FLOW IS DIFFERENCE BETWEEN INTEREST EARNED ON LIBOR LOAN (LIBOR x 66.7) INTEREST PAID ON FIXED LOAN (.06 x 66.7) = $4MM BANK IS RECEIVING $4MM ON ITS ORIGINAL LOAN EFFECTIVELY TRANSFORMS THE LOAN FROM FIXED INTEREST RATE TO LIBOR-BASED


Slide50 : A bank will receive interest of $4 million er year for 5 years fixed. It wants to swap into a floating-rate annuity. If it could borrow fixed at 6% per year, the $4 million interest would support a fixed-rate loan of 4/.06 = $66.7m. This is the notional principal amount of the swap. To construct a homemade swap, borrow $66.7 million fixed and lend the same amount at LIBOR. Cash flows are: 0 1 . . . 5 1. Borrow $66.7 fixed +66.7 -4 -(4 + 66.7) 2. Lend $66.7 floating -66.7 + LIBOR1 x 66.7 + (LIBOR5 x 66.7) + 66.7 3. Net flow 0 -4 + (LIBOR1 x 66.7) -4 + (LIBOR5 x 66.7) FRIENDLY BANK


FRIENDLY BANK : FRIENDLY BANK EASIER WAY BANK CALLS SWAP DEALER CONTRACTS FOR 5-YEAR FIXED-TO-LIBOR SWAP ON NOTIONAL PRINCIPAL OF $66.7MM STARTING PAYMENT WITH LIBOR AT 5% BANK ® $4 ® COUNTERPARTY BANK .05 x $66.67 = $3.33 COUNTERPARTY BANK ® NET = $.67 ® COUNTERPARTY


FRIENDLY BANK : FRIENDLY BANK SECOND PAYMENT BASED ON LIBOR AT YEAR 1 LIBOR INCREASES TO 6% BANK ® $4 ® COUNTERPARTY BANK .06 x $66.67 = $4 COUNTERPARTY BANK ® NET = 0 ® COUNTERPARTY


FRIENDLY BANK : FRIENDLY BANK WHAT ABOUT VALUE OF SWAP AT YEAR 2? DEPENDS ON LONG-TERM INTEREST RATES IF LONG TERM RATES INCREASE TO 7% VALUE OF 3-YEAR FIXED NOTE FALLS TO PV = 4/1.07 + 4/1.072 + (4 + 66.67)/1.073 = $64.92MM SWAP IS WORTH 66.67 - 64.92 = $1.75MM HOW DO WE KNOW SWAP IS WORTH $1.75MM? BANK CAN ENTER INTO A NEW SWAP BY AGREEING TO PAY LIBOR ON $66.67 TO RECEIVE FIXED PAYMENTS OF .07 x 66.67 = $4.67MM PER YEAR


FRIENDLY BANK : FRIENDLY BANK NEW SWAP CLOSES OUT ORIGINAL SWAP AND GENERATES $.67MM PER YEAR FOR 3 YEARS PV = .67/1.07 +.67/1.072 +.67/1.073 $1.75MM REMEMBER: INTEREST-RATE SWAPS HAVE PV = 0 WHEN ENTERED INTO OTHERWISE WHY WOULD ONE SIDE ACCEPT THE CONTRACT? VALUE CHANGES AS LONG-TERM INTEREST RATES CHANGE OVER TIME


HOW TO SET UP A HEDGE : HOW TO SET UP A HEDGE FIRM OFFSETS RISK OF OWNING ONE ASSET BY SELLING AN EQUAL AMOUNT OF ANOTHER ASSET FARMER OWNS 100,000 BUSHELS OF WHEAT AND SELLS 100,000 BUSHELS OF WHEAT FUTURES BUT WHEAT HE OWNS NOT IDENTICAL TO WHEAT HE SELLS IN THE FUTURES MARKETS DON’T MOVE PERFECTLY TOGETHER BASIS RISK 1% CHANGE IN PRICE OF WHEAT FUTURES (KANSAS WHEAT) ASSOCIATED WITH .8% CHANGE IN PRICE OF FARMER’S WHEAT NEEDS TO SELL .8 x 100,000 BUSHELS OF WHEAT FUTURES


ESTIMATING DELTA FROM PAST DATA : ESTIMATING DELTA FROM PAST DATA Example: Hedging the farmer’s wheat needs with futures Price of farmer's wheat s s s s s s s Price of Kansas City wheat s s s Delta = 0.80


HOW TO SET UP A HEDGE : HOW TO SET UP A HEDGE GENERALIZE EXAMPLE OF THE FARMER YOU OWN ASSET A WHEAT HEDGE AGAINST CHANGES IN VALUE OF A BY OFFSETTING SALE OF ANOTHER ASSET B WHEAT FUTURES EXPECTED CHANGE IN VALUE OF A = a + d x CHANGE IN VALUE OF B MEASURES SENSITIVITY OF A TO CHANGES IN VALUE OF B d IS THE HEDGE RATIO NUMBER OF UNITS OF B WHICH SHOULD BE SOLD PER UNIT OF A


HEDGE RATIO : HEDGE RATIO TRICK IS IN ESTIMATING DELTA OR HEDGE RATIO PORSCHE EXPOSED TO CHANGES IN DM/$ EXCHANGE RATE HOW MUCH DM/$ EXCHANGE RATE AFFECTS VALUE OF COMPANY? DEPENDS ON PRICE ELASTICITY OF DEMAND FOR PORSCHE CARS ABILITY TO SHIFT PRODUCTION TO LOWER-COST COUNTRIES HISTORICAL DATA MAY BE AVAILABLE DIFFERENT KINDS OF WHEAT SOMETIMES THEORY HELPS


IMMUNIZATION : IMMUNIZATION POTTERTON LEASING HAS PURCHASED EQUIPMENT RENTS IT OUT FOR 8 YEARS AT $2MM A YEAR AT 12%, PV = 2/1.12 +2/1.122 + . . . = $9.94MM POTTERTON FINANCES PURCHASE BY ISSUING 2 BONDS $1.91MM OF 12% 1-YEAR DEBT AND $8.03MM OF 12% 6-YEAR DEBT WHAT HAPPENS TO POTTERTON WHEN INTEREST RATES CHANGE?


IMMUNIZATION : IMMUNIZATION DURATION OF RENTAL INCOME = [PV(C1) x 1] /V + [PV(C2) x 2] /V + [PV(C3) x 3] /V + . . . =[2/1.12 x 1]/9.94 + [2/1.122 x 2] /9.94 + = 3.9 YEARS DURATION OF LIABILITIES DURATION OF 1-YEAR DEBT = 1 YEAR DURATION OF 6-YEAR DEBT = 4.6 YEARS DURATION OF PACKAGE OF LIABILITIES = WEIGHTED AVERAGE OF DURATIONS OF EACH ISSUE = (1.91/9.94) x DURATION OF 1-YEAR DEBT + (8.03/9.94) x DURATION OF 6-YEAR DEBT = (.192 x 1) + (.808 x 4.6) = 3.9 YEARS


IMMUNIZATION : IMMUNIZATION ASSET AND LIABILITY HAVE SAME DURATION BOTH IMPACTED EQUALLY BY CHANGE IN INTEREST RATES IF RATES RISE PV OF ITS RENTAL INCOME AND PV OF ITS LIABILITIES WILL DECLINE BY SAME AMOUNT POTTERTON HAS IMMUNIZED ITSELF AGAINST CHANGES IN INTEREST RATES HOW DID IT CALCULATE THE PROPORTION OF 1-YEAR AND 6-YEAR LOANS IN ITS OVERALL BORROWING?


IMMUNIZATION : IMMUNIZATION PACKAGE OF LOANS HAS PV OF $9.94MM AND DURATION OF 3.9 YEARS X = FRACTION OF 6-YEAR LOANS IN TOTAL BORROWING DURATION OF PACKAGE =[X x DURATION OF 6-YEAR LOAN] + [(1 - X) x DURATION OF 1-YEAR LOAN] 3.9 = [X x 4.6] + [(1 - X) x 1] X = .808 COMPANY WILL RAISE .808 x 9.94 = $8.03 IN 6-YEAR LOANS


IMMUNIZATION : IMMUNIZATION DYNAMIC HEDGE AS INTERESTS CHANGE AND AS TIME PASSES, DURATION OF ASSET NO LONGER SAME AS DURATION OF LIABILITY COMPANY HAS TO CONTINUOUSLY ADJUST DURATION OF ITS DEBT ALTERNATIVELY, CONSTRUCT DEBT ISSUE WHOSE CASH FLOWS EXACTLY MATCH RENTAL INCOME 8-YEAR $9.94MM SINKING FUND BOND SINKING FUND IS $810,000 IN YEAR 1, INCREASING BY 12% ANNUALLY TOTAL PAYMENTS OF INTERESTS AND SINKING FUND ARE $2.00MM


IMMUNIZATION : IMMUNIZATION MATCHING CASH FLOWS OF ASSET AND LIABILITY COMPANY PERFECTLY HEDGED TAKE RENTAL INCOME AND HAND IT OVER TO BONDHOLDERS MATCHING ASSETS AND LIABILITIES MAY BE EXPENSIVE TO CONSTRUCT


OPTION DELTAS : OPTION DELTAS OPTION PRICE IS TIED TO UNDERLYING STOCK PRICE OPTION DELTA THE CHANGE IN VALUE OF THE OPTION SAME AS CHANGE IN VALUE OF d SHARES OF STOCK USE OPTIONS FOR HEDGING IF YOU OWN ONE SHARE, SELL 1/d OPTIONS OPTION DELTAS CHANGE WITH CHANGE IN STOCK PRICE AND PASSAGE OF TIME HEDGE NEEDS TO BE CONTINUOUSLY RESET


OPTIONS, DELTAS AND BETAS : OPTIONS, DELTAS AND BETAS HEDGING FINANCIAL ASSETS YOU HOLD WELL DIVERSIFIED PORTFOLIO OF STOCKS WITH BETA = 1.0 WANT TO LOCK IN PORTFOLIO VALUE AT YEAR END SELL CALLS ON INDEX NEED TO ADJUST OPTION POSITION FREQUENTLY SIMPLER TO SELL INDEX FUTURES BUT WHEN YOU WANT TO LOCK IN VALUE OF AN INDIVIDUAL STOCK HAVE TO HEDGE WITH OPTIONS FUTURES CONTRACTS NOT AVAILABLE ON INDIVIDUAL STOCKS


OPTIONS, DELTAS AND BETAS : OPTIONS, DELTAS AND BETAS WHAT IF YOUR PORTFOLIO HAS BETA OF 0.6? HEDGE REQUIRES 40% FEWER FUTURES CONTRACTS ALSO SOME BASIS RISK PORTFOLIO NOT PERFECTLY CORRELATED WITH MARKET EXPECTED CHANGE IN VALUE OF STOCK OR PORTFOLIO, A = a + b x CHANGE IN VALUE OF MARKET INDEX, B DEFINITION OF d EXPECTED CHANGE IN VALUE OF A = a + d x CHANGE IN VALUE OF B WHEN A IS A STOCK OR PORTFOLIO AND B MARKET INDEX HEDGE RATIO d IS b


IS DERIVATIVE A BAD WORD? : IS DERIVATIVE A BAD WORD? FARMER SELLS WHEAT FUTURES TO REDUCE BUSINESS RISK SPECULATOR SELLS WHEAT FUTURES WITHOUT UNDERLYING POSITION NOT REDUCING RISK PROVIDES LEVERAGE PROFITS OR LOSSES MANY TIMES INITIAL OUTLAY SUCCESSFUL DERIVATIVES MARKET NEEDS SPECULATORS


HOW VALUABLE FIRMS THINK DERIVATIVES ARE IN CONTROLLING RISK : HOW VALUABLE FIRMS THINK DERIVATIVES ARE IN CONTROLLING RISK Source: G30 user survey


SPECULATION : SPECULATION BUT SPECULATION MAY GET COMPANIES INTO TROUBLE METALLGESELLSCHAFT LOST $1.3 BILLION TRADING OIL FUTURES BUT IS THIS BECAUSE ACCOUNTING SYSTEM RECOGNIZED LOSS ON FUTURES POSITION BUT NOT PROFITS ON CONTRACTS TO DELIVER OIL AT FIXED PRICE? NOT CLEAR IN 1995, BARING BROTHERS (200-YEAR OLD BRITISH MERCHANT BANK) BECAME INSOLVENT TRADER IN ITS SINGAPORE OFFICE SPECULATED ON DIRECTION OF JAPANESE STOCK MARKET LOST $1.4 BILLION


SPECULATION : SPECULATION SOME GROUND RULES FOR COMPANIES NO SURPRISES MANAGEMENT SHOULD KNOW WHAT BETS COMPANY IS TAKING WHAT WILL HAPPEN IF INTEREST RATES MOVE 1 PER CENT ONLY SPECULATE WHEN FIRM HAS COMPARATIVE ADVANTAGE