HEDGING & RELATED RISK

MANAGEMENT TECHNIQUES
 Factors affecting hedging
• Risk profile associated with cash position.
• Type of risk(all risk or downside risk) .
• Cost of hedging with different hedging
instruments.
• Effectiveness of different hedging instruments.
 Hedge ratio
• Hedge ratio is number of units of the hedging
instrument necessary to hedge one unit of cash
position
• Naive Approach.
• Johnson ‘s and Stein’s methodology.
• Johnson/Stein/Ederington (JSE) methodology.
• Dollar Value Basis Point (DV01) Model.
 JOHNSON/STEIN APPROACH

• Goal was to minimize the variance of profit

associated with the combined cash and futures
position.
• This is applied to traditional commodities.
 JSE METHODOLOGY
• Regress the change in spot price against change in
futures price.
• ΔS=a+b*ΔF +u
where ∆S = S(t) - S(t-1)
∆F = F (t,T) – F(t-1,T)
u= error.
b= slope, minimum variance hedge ratio.
a= intercept term.
 ASSUMPTION
• Regression technique assumes that relationship
between regression variable (S) and explanatory
variable (F) is stable
• Future price converges to spot price where basis
vanishes at time of delivery.
 ASSUMED BEHAVIOUR &
ACTUAL BEHAVIOUR OF BASIS
Assumed
path

F(t,T)

Assumed
basis
Actual
Actual
path
basis
S(t)

Time T
Contract
expiry
 STORABLE COMMODITIES

• The basis is explained by Cost of Carrying.

F(t,T) = S(t) * [1+r(t,T) + w(t,T) – c(t,T)]
where r(t,T) is interest rate.
w(t,T) is storage cost.
c(t,T) is convenience yield.
• As time converges t approaches expiry T .
• The cost of carry converges to zero, so basis must
vanish.
 DV01
• Its applicable to hedging of interest rate risk .
HR = DV01C * βY
DV01f
• DV01 of cash & futures are continuously changing
but not necessarily at equal rates.
• Yield beta should be periodically re-estimated.
• It allows the financial institution to convert all it s
cash position to common bench mark.
15 year XYZ bond offering semi annual coupon priced to yield
9.875%. The bond trader estimates it should yield only
9.640%. So bond is under valued. The trader buys $10 million
face value of bond. The trader identifies 7 year ABC bond
offering semi annual coupon to yield 8.25% he estimates it to
yield 8.48%. Bond is over valued. The trader sells $10 million
face value of the bond. The bonds are at par the proceeds from
short sale of ABC bond are sufficient to pay for XYZ bond.
 RISK MANAGEMENT REPORT

BOND POSITION MARKET DV01 βY HR BE

VALUE

XYZ +10 M +10 M 0.077369 0.54 0.42306 + 4.2306M

15 year

ABC -10M -10M 0.052366 0.59 0.31285 - 3.1285M

7 year

0 0 +1.102M
 Recent improvements in Hedging
Theory
• Significant improvements in the works of HKM.

• To understand the improvements:

– Calculate the hedge ratio using HKM in direct hedge
– HKM’s extension to cross hedges
– Benefits from diversification by composite approach.
• Direct hedge employs future contract, written on an
underlying asset delivered in the same market, while
cross hedge is done in a different market.
• Example: Winter wheat
 Hedge Ratio in direct hedge
• Future price converges to spot price as futures
contract approaches expiry.
• F(t,T) = S(t).[1+r+w-c] ; r+w-c: cost of carry
• State the cost of carry as continuously compounded
rate (FV=PV.e^in)
• Take r+w-c = y and
• τ = length of time until contract expiry and stated as a
fraction of year.
• F(t,T) = S(t).e^yτ
• S(t) = F(t,T).e^(-yτ)
• Take e^(-yτ) = h (hedge ratio)
• Thus, h is dependent on τ.
• To prove whether hedge ratio is estimatable.
• ln (S(t)/F(t,T)) = -yτ
• ln (S(t)/F(t,T)) = z + dτ + v ; (-y=z+dτ)
 2. Hedge Ratio in Cross Hedges
• Lets take subscript 1 for the underlying
commodity on which a futures contract is
written and subscript 2 on cash position
commodity
• S1 = F1.e^(-yτ)
• S2 = a + b.S1 + u = a + b(F1.e^(-yτ)) + u
• S2 = a + [b.e^(-yτ)].F1 + u
• Hedge Ratio, h = b.e^(-yτ)
 3. Composite hedging
• Simple hedge: contains single hedging instrument
• Composite hedging: contains multiple hedging
instruments
• Portfolio consisting of a no. of securities is less
risky.
• systematic
• unsystematic risk
• Unsystematic risk can be reduced by
diversification.
• To determine the risk-minimizing hedge ratio,
take the optimal hedge ratio, f = b.e^(-yτ)
• The basis, B = S – f.F
• The effectiveness of the hedge is found from
the coefficient of determination:
• Ρ^2 = 1 – (σB^2 / σp^2)
• Take covariance of the ith and jth bases= σi,j
• Variance of the composite hedge;
• σc ^2 = ΣinΣjn wiwj σi,j
How composite hedging benefits?
Futures Basis Spot Price Hedge
effectiveness
1 180 1225 85.3%
2 172 1225 86%
3 194 1225 84.2%

Covariance Matrix of the Bases

Futures
Futures 1 2 3
1 180 32 26
2 32 172 44
3 26 44 194
 Cost of hedging
• Speculator are as: Passive risk bearers and
active forecasters.
• Cost of hedging = f . (E[F(L,T)] – F (t,T))
• Effective hedge: degree to which it reduces
risk. The most effective hedge is the best
hedge
• Efficient hedge: Hedge, for any given cost,
provides the greatest risk reduction.
Building Block Approach to Hedging
 Concepts to be considered
• Correct methodology
• Size of the hedge
• Alternative hedge instrument
• Possibility of composite hedging
• The cost of alternative hedges
Three ways to visualize Building Blocks
approach
– By way of risk and pay off profiles
– Boxed cash flow diagrams
– Time line cash flow diagrams
 Miscellaneous risk management issues and instruments

• In the over counter options market :

• Path dependent option
• Look back options
• Option linked loans
• Other forms of risk management:
• Diversification
• Credit enhancement
• Over collateralization
• Assignment
 CHAPTER 22

CORPORATE RESTRUCTURING
AND THE LBO
Corporate restructuring and the
LBO
 Corporate Restructuring
• The term corporate restructuring
encompasses three distinct ,but related,
groups of activities – Expansion, Contraction,
Ownership and control under its umbrella.
• It is the perception of value gains that
motivates the corporate restructuring and it is
the financial engineering which makes the
restructuring possible.
• Expansion includes :-
 Mergers- a)Horizontal merger
b)Vertical merger
c)Conglomerate merger
 Consolidations
 Acquisitions
 Joint ventures which result in an enlargement
of a firm or its scope of operations
 Strategies employed in corporate
acquisition
 Friendly takeover

 Hostile takeover
 Defenses against takeovers
 Target block repurchase with an
accompanying Standstill agreement. Also
called as Greenmail.
 Leveraged Recapitalizations(Recap).
 Poison puts.
 White knight through a management–led
leverage buyout or Management
buyout(MBO).
• Contraction results in a smaller firm rather
than a larger one.
• Corporate contraction occurs as a result of
disposition of assets(sell-offs) which include:-
 Spin offs- a) split-off
b) split -up
 Divestitures
 Equity carve-out
 MERGERS
• Merger is of three types-:
1) Horizontal Merger- For eg Daimler-Benz and

Chrystler.
2) Vertical Merger- For eg Apple with Intel
3) Conglomerate Merger- For eg Bharti Airtel
with Walmart.
 ACQUISITIONS
• Acquisitions consist of two strategies namely-:
Friendly Takeover-: for eg diachy- ranbaxy
Hostile Takeover-: for eg take over of a
company called three par by hp.
• Contractions consist of the sell-offs which means
disposition of assets.
• It can be classified into-:
(i) Spin-off-: parent company transfers some of its assets
and liabilities to a new firm created for that purpose.
(ii)Divestiture-: involves an out and out sale of assets for
cash.
(iii)Carve-out-:contraction between a spin-off and a
divestiture.
.
• Steps of having Ownership and Control are-:
(i)Determining the terms of the members of the
board.
(ii)Issuing voting power to the members.
(iii)Providing the members with sufficient
power.
The leveraged Buyout
• In 1980, publicly traded firms went private by
employing Leverage buyout or LBO
• The acquisition of another company using a
significant amount of borrowed money (bonds
or loans) to meet the cost of acquisition
• Leveraged buyout can be successful if-
1.its assets can be disposed of at a profit
2.The acquires company has an healthy cash
flow
 Tools for going private
1. Junk bonds
2. Private placements
3. Bridge financing
4. Merchant baking
• Junk bonds- high-risk, non-investment-grade bond with a low credit
rating, usually BB or lower.
•  Junk bonds typically offer interest rates 3-4% percentage points
higher than safer government issues.
• Junk bonds have a issue of RESET PROVISION

• Private Placements-The sale of securities to a relatively small

number of select investors as a way of raising capital
• Investors involved in private placements are usually large banks,
mutual funds, insurance companies and pension funds.
• Investors receives a higher return as registration costs are avoided
• Merchant Banking-is a new Endeavour for investment
banks.
• The investment bank takes a portion of the target firms’
equity on its own books.i.e. the investment bank becomes a
equity partner in the leveraged buyout
• Bridge Financing-is a method of financing, used to
maintain liquidity while waiting for an anticipated and
reasonably expected inflow of cash
• These funds are usually supplied by the investment
bank underwriting the new issue. As payment, the company
acquiring the bridge financing will give a number of stock at
a discount of the issue price to the underwriters
•  For example-, when selling a house, the owner may not
receive the cash for 90 days, but has already purchased a
new home and must pay for it in 30 days. Bridge financing
covers the 60 day gap in cash flows.
Sources of value in a leveraged Buyout
• Creates efficiency-decision making efficiency
• Tax benefits
• Agency problems-ownership and control
become one and the same,reduces the agency
costs
Disadvantages of leveraged buyout
1. Cause layoffs of the firm’s employees
2. Damage debt markets
3. Force management to focus on short term
goals, by reducing advertising and research
budgets
4. Results in bankruptcies of the firm
Typical leveraged Buyout
 XYZ CORP.
BALANCE SHEET 1985
(ALL VALUES IN MILLIONS)
ASSETS Liability & equity
Current Assets Current Liabilities
Cash 0.20 accruals 0.25
Marketable Securities 1.55 accounts payables 0.75
Inventory 1.75 notes payable 0.50
Receivables 0.50
1.50
4.00 Long term debt 2.50
Fixed assets
Depreciable 12.00 Equity
Less cum dep (12.00) Common stock 0.50
Net 0.00 retained earnings 1.50
Non depreciable 2.00 2.00
2.00
Total assets 6.00 Total liability & Equity 6.00
 Profit & loss -1985
(all values in millions)

• Sales 15.00
• Cost of goods sold 8.00
• Gross profit 7.00
• Selling and administrative 5.50
• Operating profit before depreciation 1.50
• Depreciation 0.00
• Operating profit 1.50
• Interest expense 0.35
• Earnings before taxes 1.15
• Taxes (40%) 0.46
• Earnings after taxes 0.69
Cash flow= earnings after taxes +depreciation
=$0.69million+ $0.00 million
=$0.69 million
 XYZ CORP.
BALANCE SHEET 1985
(ALL VALUES IN MILLIONS)
ASSETS Liability & equity
Current Assets Current Liabilities
Cash 0.20 accruals 0.25
Marketable Securities 1.55 accounts payables 0.75
Inventory 1.75 notes payable 0.50
Receivables 0.50
1.50
4.00 Long term debt 11.50
Fixed assets
Depreciable 10.00 Equity
Less cum dep (10.00) common stock 3.00
Net 10.00 retained earnings 0.00
Non depreciable 2.00 3.00
12.00
Total assets 16.00 total liability & equity 16.00
 Profit & loss
(all values in millions)
 The financial engineer at work
• Engineers job : analyze the cash flows and
structuring a deal
• Issues:
– Sensitiveness of the cash flows
– Payment of buyout group for the firm
– Kind of debt and how much debt
– ESOP structure
– Cash out
 Arbitrage : From the Ancient to
the Modern
Arbitrage
It involve simultaneous transaction in two or more
market in order to exploit price discrepancy
between the market

1.Spatial or Geographic Arbitrage

The arbitrage, sometime spelled arbitrager,seeks
to profit from the price between the market
 LAW OF ONE PRICE
Law of one price=
Pi=Pj+Zi,j
OR
Pi=Pj.Ej+Zi,j

2.Temporal Arbitrage or carrying-charge

Arbitrage
Fi(t,T)=Pi(T)+Gi(t,T)
• 3.Risk and taxe Arbitrage

• 4.Academic or pure Arbitrage

 Synthetic securities
 It is a cash flow stream creation from a
combination or a decomposition of cash flows
associated with asset of instruments

 Two of first synthetic instrument

• A)synthetic puts
• B)synthetic zero

 Put call parity theorem

 Synthesizing derivatives
• This is a multiperiod option , such as caps and
floor can be synthesized from a strip of a
single period put or single period call option.
 Cash and carry synthetic
• A cash and carry transaction involves the
purchase of an instrument and simultaneous
sale of of a future contract against it in order
to create a synthetic short-term instrument
.such synthetic short term instrument are
created in order to earn low risk short terms
rates.
• Suppose 20.5 year treasury bond carries a
coupon of 8.00% and is currently price at 93 . At
16/2

this price instrument provides a yield to maturity

8.68 %this instrument is deliverable against the
six month forward t-bond futures with a
conversion factor of 1000. that is ,100,000 face
value of this bond is deliverable per futures
contract .at the time of delivery, the bond it self
have a maturity of 20 yearsthe future contract is
price at 932/32 so what is the return who buys the
bond and sell it future.
• First The investor will receive a coupon $4 in a 6
month. 8/2=4
• Now the investor is going to sell the instrument=
93*32+16/32
• =93.0625
• Thus the investor have 4+93.0625
• the investor will get =97.0625
• Current cost is =93*32+2/3
• =93.50
• Bey=(97.0625/93.50-10)*2
• =7.62%
 Cash and carry in arbitrage:-
Enhancing portfolio return
• If the m.k.t were always efficient ,synthetic t-
bill return the same rate as real t-bill. But it
depends on the mkt

• Let us suppose
• Strategy repo rate return net-profit
• Cash and carry 7.34 7.62 28bps
• Buy t-bill 7.42 7.62 20bps
 Synthetic long bonds
• In this we would buy a 3 month t-bill together
with t-bond futures. This strategy require us
to equate the volatility of the bill/future
position with the voltality of the target bond
that is the real bond we are attempting to
sythesize.
• Suppose you have dividend of $0.0765 at the
time the future contract matures and the t-
bond has a dividend of $0.0684. the yield beta
beta is 1000. how many futures having a face
value of$0.1 million does it take to replicate a
$50 million position in target bond .asuming
the target bond is $47.5625 million.
• Determine the hedge ratio:-

• Hedge ratio= 0.0765/0.0684*1

1.118
Determine the face value of futures position:-

Face value of future=hedge ratio *face value of position to

be replicated
=1.1184*$50milion
=$55.92
Determine the no of future contract needed:=

No of futures= face value of future needed/face value of

one futures
55.92/0.1=559
 SWAP
• SYNTHESIZING A DUAL CURRENCYBOND
A dual currency bond is a bond is the bond which is sold and
redeemed in one currency with coupon payment is another
currency.
 A fixed-for-fixed currency swap can itself be synthesized by
combining a fixed-for-floating currency swap with a fixed-for-
floating interest rates swap.
Synthesizing a Foreign-pay Zero
The investor has to buy the treasury zero and then enter two separate
swaps. The first swap is zero coupon interest rate swap in which the
investor is the zero coupon payer floating-rate receiver. The second
swap is a yen/ dollar zero coupon currency swap in which the investor
is zero coupon yen receiver and floating rate payer.
 The net cash flow after the cancellation the all set of
transaction appears to the end result in synthetic yen-
pay zero coupon bond.
 Synthetic Equity
A derivative instrument with the essential risk/reward
characteristics of a direct investment in a stock, a specific basket
of stocks, or an appropriately weighted basket of stocks
equivalent to a stock index.
 Qualitative differences between
synthetic and real securities
• Identifying Qualitative differences
Qualitative consideration
Alternative description cost issue time cost may rise

1 Fixed rate 13.80% 3 months No

issue(public)

2 Fixed rate 14.00% 7days No

issue(public)

3 FRN with swap 13.50% 3 months No

4 CP with rollover 12.05% 7 days Yes

with swap
Tax Driven Deals
 Introduction
• A financial deal cannot exist without involving
tax issues.
• Tax issues influence how a deal is structured.
Such deals are tax driven.
 Case 1: Preventing a hostile takeover
Situation:
• Celene Corporation is fearful of a hostile
takeover by KEF Enterprises.
• To discourage this attempt Celene plans to
dilute its stock ownership.
• Celene plans to adopt a “poison pill” plan.
Danger
• The “poison pill” rights can be viewed by the
tax authorities as a dividend distribution of
stock.
• The shareholders would be reluctant to the
poison pill plan.
An engineered solution
• Poison pill plans should be adopted which
creates inchoate rights.
Case 2: Recapitalization of the firm
Situation:
• RUK’s Corporation is heavily on debt and wants to
recapitalize.

• It plans to exchange securities previously issued for senior

notes.

• The prospective purchasers will be reluctant to buy them

unless RUK enhances the offer in a visible and tangible
manner.

• They want to offer one of the following:

– Cash rebates
– Market discount bonds
– RUK common stock
Danger:
• In a recapitalization, a gain derived from the
value of property ,other than securities, is
considered a realized gain for taxable
purpose.
An Engineered Solution
• RUK’s common stock is consider a security so
its inclusion in the offer will not generate
realized gain.
An instrument can be considered a security on
the following rules:
– Whether an instrument is equity based or debt
based
– The length of the instrument’s term
– Whether an instrument is secured
– The likelihood of repayment on or before the
maturity date
Case 3: Non-profits: Tax on Unrelated
Business Income
Situation:
• Starburst Corporation is a nonprofit organization who
owns an extensive portfolio of investments.

• It is planned that Starburst employ various risk

management techniques to minimize the risks to its
portfolio.

• Starburst has asked its financial engineers to look at

the tax effect of using risk management techniques.
Dangers:
• Non profit organizations are taxed on their
unrelated business income.
• Investment property within the Internal
Code’s definition of “debt-financed” property
generates unrelated business income.
• Borrowed funds are considered as debt-
financed.
An Engineered Solution:
• Starburst can make a interest rate swap
arrangement.
 Meeting the Need for Short-Term Financing

Situation:
• Slade Enterprises needs to obtain short-term
financing. Slade wants to avoid offering an
instrument which federal tax authorities
might view as a debt instrument. Slade is in
very low tax bracket.
 Avoidance
of debt To avoid tax
instrument

Tax exemption for

Short Term dividends
Preferred-share paid

Sell out 46 days holding

Equity security
any period(dividends
time paid)

Avoidance of debt
Auction

Investor perception
Success Failure

Penalty
rate Investor security
paid
 Self-liquidating Preferred Stock
Situation
Emerald Enterprises,Inc wants to acquire Earl
Corporation. Emerald would like this reorganization to be
tax free event to the extent possible .
Danger
IRS
CONTINUITY OF PROPRIETARY INTEREST
SECURITIES TO SHARE

45 %of amount of
CONTINUITY OF PROPRIETARY
cash paid to Earl’s
INTEREST
share

50%CASH &
50% SHARES

STOCK ISSUED AT $50 WILL BE

SELF LIQUIDATION REEDEMED AFTER FIVE YEAR NOT
PREFFERED STOCK LESS THAN $50
 Where Is a White Knight When You
Need One
Situation
Bannor Corporation is fearful of a hostile
takeover by Satiuz Enterprises.Bannor has
good relations with Delea Corporation which
is not interested in or capable of taking over
Bannor.
Danger
Satiuz has prepared an attractive offer to
Bannor’s share holders.
 TAKE OVER
SATIUZ PROVIDING EXCESSIVE CASH OR
VALUABLE SECURITIES WITH NO CURRENT
DELEA CONVERTIBLE TAX GAIN TO BANNOR’S SHAREHOLDERS
PREFERRED STOCK

ABOVE MARKET DIVIDEND RATE

& BELOW MARKET
CONVERSION PREMIUM

The company sells the shares to third-

party at below-market prices. White mail
WHITE MAIL
may not halt the takeover attempt all
together, but it does make the deal

TAKE OVER INSURANCE

 Bond swapping
• Techniques to lower your taxes and improve
the quality of your portfolio
Swapping can be a very effective investment
tool to:
• increase the quality of your portfolio;
• increase your total return;
• benefit from interest rate changes; and
 Bond Swap
• Telva Corporation plans to issue a bond which will be
publicly traded. Telva might swap the Bond in the future
with a new bond which reduces the interest it must
pay.Telva believes that a bond swap will work.
Danger
• If the issue price of Telva first bond for tax purposes will be
high than the issue price of the new bond ,this would
produce a significant tax gain.
• The IRS does not require an actual physical change of
bonds to find a bond SWAP occurred. The change of
material terms of an existing bond can be de facto.
Solution
• Adding a clause in the original bond’s indenture for
the deduction in interest rate.
Responses
• The repayment of the principal could be viewed as
the primary focus of a bond ,bond interest might be
viewed as a less material aspect of the bond.
 Renegotiating Debt

Situation:

• Roth Corporation has issued $10 million worth

of publicly traded bonds. Each Bond has a
$1000 face value. After the economic
difficulties, The trading price of the bonds has
dropped to $700.
 Cont..
Solution:
• The issuance of junk bonds to replace the current bonds.
Response
• New debt to generate cancellation of indebtedness income to
the extent that the principal amount of the retired debt
exceeds the IRS’s new definition of the “Issue Price” of the
new debt. (As per the New IRS rules.)
• Financial engineers would suggest the use of nonpublic
traded debt whenever possible in this situation.
 Taxes and Costs on Real Estate Transfers
Situation:
• Volinstaad is unable to manage a wine production and
distribution business over the long term.
• Volinstaad seeks to aquire the real estate needed to
grow and store large quantities of grape over the next
two years.
• Volinstaad Corporation anticipates that it will have
applied $30 million of resources, of which $20 million
would be real estate costs, and would be able to sell the
entire business and its assets for $40 million
 Taxes and Costs on Real Estate Transfers

Situation:
• Volinstaad buys the $20 million worth of real estate,
implements its plan and sells the real estate.

• The transfer of land would generate the special costs

and local taxes ($17,42,500) including Title
Insurance, Transfer Tax, Mortgage Recording Tax,
Filling of Deed, Points to bank and application Fees.
 Cont…

Solution:

• Avoiding the transfer and closing

 Real Property Taxes

Situation:
Tuck Corporation wants to buy one hundred acres
of industrial property as part of its expansionn
efforts. According to Tuck’s real estate
department has located the following properties-

1. 100 acre parcel of land Price - $5 million

2. 250 acre parcel of land Price - $6 million
3. 40 acre parcel of land Price - $3 million
 Real Property Taxes

Situation:
Tuck Corporation go with second property
option which is a farm called Southbridge
(Humbull Farms the owner). Tuck to buy it for
$1.5 million down
Tuck’s CEO approves the deal and signs the
contract to buy Southbridge.
After that..
 Cont…

Solution:

• Truck rent the land to Humbull or lease for per

year and reduce their property tax from
$90000 annual to $10000 annual.