Derivatives and Hedging Risk

Chapter
25 Derivatives and Hedging Risk

Key Concepts and Skills
 Understand the basics of forward and futures

contracts
 Understand how derivatives can be used to hedge

risks faced by the corporation
Copyright © 2016 McGraw-Hill Education. All rights reserved.

No reproduction or distribution without the prior written consent of McGraw-Hill Education.
25-2
Chapter Outline
25.1 Derivatives, Hedging, and Risk

25.2 Forward Contracts
25.3 Futures Contracts
25.4 Hedging
25.5 Interest Rate Futures Contracts
25.6 Duration Hedging
25.7 Swap Contracts
25.8 Actual Use of Derivatives

25-3
25.2 Forward Contracts
 A forward contract specifies that a certain commodity
will be exchanged at a specified time in the future at a
price specified today.
◦ Its not an option: both parties are expected to hold up their
end of the deal.
◦ If you have ever ordered a textbook that was not in stock, you
have entered into a forward contract.

25-4
25.3 Futures Contracts
 A futures contract is like a forward contract:

◦ It specifies that a certain commodity will be exchanged at a
specified time in the future at a price specified today.
 A futures contract is different from a forward:

◦ Futures are standardized contracts trading on organized
exchanges with daily resettlement (“marking to market”)
through a clearinghouse.

25-5
Futures Contracts
 Standardizing Features
◦ Contract Size
◦ Delivery Month
 Daily resettlement
◦ Minimizes the chance of default
 Initial Margin
◦ About 4-10% of contract value
◦ Cash or T-bills held in a street name at your
brokerage

25-6
Daily Resettlement: An Example
Suppose you want to speculate on a rise in the $/¥
exchange rate (specifically, you think that the dollar will
appreciate).
Currency per
U.S. $ equivalent U.S. $
Wed Tue Wed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1-month forward 0.006993007 0.007042254 143 142
3-months forward 0.006666667 0.006711409 150 149
6-months forward 0.00625 0.006289308 160 159
Currently $1 = ¥140.
The 3-month forward price is $1=¥150.
25-7
 Currently $1 = ¥140, and it appears that the dollar is
strengthening.
 If you enter into a 3-month futures contract to sell ¥
at the rate of $1 = ¥150 you will profit if the yen
depreciates. The contract size is ¥12,500,000
 Your initial margin is 4% of the contract value:
$1
$3,333.33 = 0.04 × ¥12,500,000 ×
¥150

25-8
If tomorrow the futures rate closes at $1 = ¥149, then
your position’s value drops (¥ appreciated).
Your original agreement was to sell ¥12,500,000 and
receive $83,333.33:
$83,333.33 = ¥12,500,000 × $1
¥150
But, ¥12,500,000 is now worth $83,892.62:
$1
$83,892.62 = ¥12,500,000 ×
¥149
You have lost $559.29 overnight.
25-9
 The $559.29 comes out of your $3,333.33 margin
account, leaving $2,774.04.
 This is short of the $3,355.70 required for a new
position.
$1
$3,355.70 = 0.04 × ¥12,500,000 ×
¥149
Your broker will let you slide until you run through
your maintenance margin. Then you must post
additional funds, or your position will be closed out.
This is usually done with a reversing trade.
25-10
Selected Futures Contracts
Contract Contract Size Exchange
Agricultural
Corn 5,000 bushels Chicago BOT
Wheat 5,000 bushels Chicago & KC
Cocoa 10 metric tons CSCE
OJ 15,000 lbs. CTN
Metals & Petroleum
Copper 25,000 lbs. CMX
Gold 100 troy oz. CMX
Unleaded gasoline 42,000 gal. NYM
Financial
British Pound £62,500 IMM
Japanese Yen ¥12.5 million IMM
Eurodollar $1 million LIFFE
25-11
Futures Markets
 The CME Group is by far the largest, consolidating:
◦ Chicago Board of Trade
◦ Chicago Mercantile Exchange
◦ New York Mercantile Exchange
 Others include:
◦ The London International Financial Futures Exchange

25-12
Wall Street Journal Futures Price Quotes
Highest price that day Lifetime Open
Open High Low Settle Change High Low Interest
Highest and lowest prices over the lifetime of the contract.
Corn (CBT) 5,000 bu.; cents per bu.
July 179 180 178.25 178.5 -1.5 312 177 2,837
Sept 186 186.5 184 186 -.75 280 184 104,900
Dec 196 197 194 196.5 -.25 291.25 194 175,187
TREASURY BONDS (CBT) - $1,000,000; pts. 32nds of 100%

Sept 117-05 117-21 116-27 117-05 +5 131-06 111-15 647,560
Dec 116-19 117-05 116-12 116-21 +5 128-28 111-06 13,857
Opening price Closing price Daily Change
DJ INDUSTRIAL AVERAGE (CBOT) - $10 times average
Sept 11200 11285 11145 11241 -17 11324 7875 18,530
Dec 11287 11385 11255 11349 -17 11430 7987 1,599
Lowest price that day
Expiry month Number of open contracts
25-13
Basic Futures Relationships
 Open Interest refers to the number of contracts
outstanding for a particular delivery month.
 Open interest is a good proxy for the demand for a

contract.
 Some refer to open interest as the depth of the

market. The breadth of the market would be how
many different contracts (expiry month) are
outstanding.
25-14
25.4 Hedging
 Two counterparties with offsetting risks can eliminate
risk.
◦ For example, if a wheat farmer and a flour mill
enter into a forward contract, they can eliminate
the risk each other faces regarding the future price
of wheat.
 Hedgers can also transfer price risk to speculators,
who absorb price risk from hedgers.
 Speculating: Long vs. Short

25-15
Hedging and Speculating: Example
You speculate that copper will go up in price, so you go
long 10 copper contracts for delivery in 3 months. A
contract is 25,000 pounds in cents per pound and is at
$3.70 per pound, or $92,500 per contract.
If futures prices rise by 5 cents, you will gain:

Gain = 25,000 × .05 × 10 = $12,500
If prices decrease by 5 cents, your loss is:

Loss = 25,000 ×( –.05) × 10 = –$12,500

25-16
Hedging: How many contracts?
You are a farmer, and you will harvest 50,000 bushels
of corn in 3 months. You want to hedge against a
price decrease. Corn is quoted in cents per bushel at
5,000 bushels per contract. It is currently at $5.30
(or 530 cents) for a contract 3 months out, and the
spot price is $5.25.
To hedge, you will sell 10 corn futures contracts:
50,000
10 contracts =
5,000bushels
bushels per
contract
Now you can quit worrying about the price of corn
and get back to worrying about the weather.
25-17
25.5 Interest Rate Futures Contracts
 Pricing of Treasury Bonds
 Pricing of Forward Contracts
 Futures Contracts
 Hedging in Interest Rate Futures

25-18
Pricing of Treasury Bonds
Consider a Treasury bond that pays a semiannual
coupon of $C for the next T years:
◦ The yield to maturity is R
C C C CF
…
0 1 2 3 2T
Value of the T-bond under a flat term structure
= PV
 offace value + PV 
of coupon payments
F C  1 
PV  T  1  T 
(1 R) R  (1 R) 
25-19
Pricing of Treasury Bonds
If the term structure of interest rates is not flat, then
we need to discount the payments at different rates
depending upon maturity.
C C C CF
…
0 1 2 3 2T
= PV of face value + PV of coupon payments
   
C C C CF
PV   2  3 L  T
 (1 R1 ) (1 R2 ) (1 R3 ) (1 R2T )
25-20
Pricing of Forward Contracts
An N-period forward contract on that T-Bond:
Pforward C C C CF
…
0 N N+1 N+2 N+3 N+2T
Can be valued as the present value of the forward price.
    Pforward 
PV  N
(1 RN )
C C C CF
 2  3 L  T
(1 RN 1 ) (1 RN 2 ) (1 RN  3 ) (1 RN  2T )
PV  N
 (1 R N )
 25-21
Pricing of Forward Contracts: Example
Find the value of a 5-year forward contract on a 20-year T-bond.
The coupon rate is 6 percent per annum, and payments are made
semiannually on a par value of $1,000.
N 40 = 20 × 2 The Yield to Maturity is 5
percent.
I/Y 5 First, set your calculator to 2
payments per year.
PV –1,125.51
Then enter what you know
1,000 × .06 and solve for the value of a
PMT 30 = 20-year Treasury bond at the
2 maturity of the forward
FV 1,000 contract.
25-22
Pricing of Forward Contracts: Example
First, set your calculator to 1 payment per year.
Then, use the cash flow menu:
CF0 0 I 5
CF1 0 NPV 881.86
F1 5
CF2 –1,125.51
F2 1
25-23
Pricing of Futures Contracts
 The pricing equation given above will be a good
approximation.
 The only real difference is the daily resettlement.

25-24
Hedging in Interest Rate Futures
 A mortgage lender who has agreed to loan money in
the future at prices set today can hedge by selling
those mortgages forward.
 It may be difficult to find a counterparty in the
forward who wants the precise mix of risk, maturity,
and size.
 It is likely to be easier and cheaper to use interest rate
futures contracts.

25-25
25.6 Duration Hedging
 As an alternative to hedging with futures or forwards,
one can hedge by matching the interest rate risk of
assets with the interest rate risk of liabilities.
 Duration is the key to measuring interest rate risk.

25-26
Duration Hedging
 Duration measures the combined effect of maturity,
coupon rate, and YTM on a bond’s price sensitivity
to interest rates.
◦ Measure of the bond’s effective maturity
◦ Measure of the average life of the security
◦ Weighted average maturity of the bond’s cash
flows

25-27
Duration Formula
PV (C1 )  1 PV (C2 )  2 L  PV (CT )  T

D
PV
N
Ct  t
 (1 R)t
D  tN1
Ct
 (1 R)t
 t 1
25-28
Calculating Duration: Example
Calculate the duration of a three-year bond that

pays a semiannual coupon of $40 and has a $1,000
par value when the YTM is 8%.

25-29
Calculating Duration: Example
Discount Present Years x PV
Years Cash flow factor value / Bond price
0.5 $40.00 0.96154 $38.46 0.0192

1 $40.00 0.92456 $36.98 0.0370
1.5 $40.00 0.88900 $35.56 0.0533
2 $40.00 0.85480 $34.19 0.0684
2.5 $40.00 0.82193 $32.88 0.0822
3 $1,040.00 0.79031 $821.93 2.4658
$1,000.00 2.7259 years
Bond price Bond duration
Duration is expressed in units of time, usually years.
25-30
Duration
Properties:
◦ Longer maturity, longer duration
◦ Duration increases at a decreasing rate
◦ Higher coupon, shorter duration
◦ Higher yield, shorter duration
 Zero coupon bond: duration = maturity

25-31
25.7 Swaps Contracts
 In a swap, two counterparties consent to a
contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
 There are two types of interest rate swaps:
◦ Single currency interest rate swap
 “Plain vanilla” fixed-for-floating swaps are often just
called interest rate swaps.
◦ Cross-Currency interest rate swap
 This is often called a currency swap; fixed for fixed rate
debt service in two (or more) currencies.

25-32
The Swap Bank
 A swap bank is a generic term to describe a financial
institution that facilitates swaps between
counterparties.
 The swap bank can serve as either a broker or a
dealer.
◦ As a broker, the swap bank matches counterparties but does
not assume any of the risks of the swap.
◦ As a dealer, the swap bank stands ready to accept either side
of a currency swap, and then later lay off their risk, or
match it with a counterparty.

25-33
An Example of an Interest Rate Swap
 Consider this example of a “plain vanilla” interest rate
swap.
 Bank A is a AAA-rated international bank located in the
U.K. and wishes to raise $10,000,000 to finance floating-
rate Eurodollar loans.
◦ Bank A is considering issuing 5-year fixed-rate Eurodollar
bonds at 10 percent.
◦ It would make more sense to for the bank to issue floating-rate
notes at LIBOR to finance floating-rate Eurodollar loans.

25-34
 Firm B is a BBB-rated U.S. company. It needs
$10,000,000 to finance an investment with a five-year
economic life.
◦ Firm B is considering issuing 5-year fixed-rate Eurodollar
bonds at 11.75 percent.
◦ Alternatively, firm B can raise the money by issuing 5-year
floating-rate notes at LIBOR + ½ percent.
◦ Firm B would prefer to borrow at a fixed rate.

25-35
The borrowing opportunities of the two firms are:

COMPANY B BANK A
Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

25-36
Swap The swap bank makes
this offer to Bank A: You
Bank
10 3/8% pay LIBOR – 1/8 % per
year on $10 million for 5
LIBOR – 1/8% years, and we will pay
Bank you 10 3/8% on $10
A million for 5 years
COMPANY B BANK A

25-37
½% of $10,000,000 =
$50,000. That’s quite
Swap Here’s what’s in it for Bank A:
a cost savings per
They can borrow externally at
year for 5 years.
Bank 10% fixed and have a net
10 3/8% borrowing position of
LIBOR – 1/8%
-10 3/8 + 10 + (LIBOR – 1/8) =
Bank LIBOR – ½ %, which is ½ %

10% better than they can borrow
A floating without a swap.
COMPANY B BANK A
25-38
The swap bank makes
this offer to company
B: You pay us 10½% Swap
per year on $10 million
for 5 years, and we will Bank
pay you LIBOR – ¼ % 10 ½%
per year on $10 million LIBOR – ¼%
for 5 years.
Company
B
COMPANY B BANK A

25-39
Here’s what’s in it for B:
½ % of $10,000,000 =
Swap $50,000 that’s quite a cost
Bank savings per year for 5
years.
They can borrow externally at 10 ½%
LIBOR + ½ % and have a net LIBOR – ¼%

borrowing position of Company LIBOR
+ ½%
10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% B
which is ½% better than they can borrow floating.
COMPANY B BANK A
25-40
The swap bank makes money too. ¼% of $10 million
Swap = $25,000 per year
for 5 years.
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
A 10 ½ - 10 3/8 = 1/8 B
¼
COMPANY B BANK A
25-41
The swap bank makes ¼%
Swap
Bank
10 3/8% 10 ½%
LIBOR – 1/8% LIBOR – ¼%

Bank Company
A B
A saves ½% B saves ½%
COMPANY B BANK A
25-42
An Example of a Currency Swap
 Suppose a U.S. MNC wants to finance a £10,000,000
expansion of a British plant.
 They could borrow dollars in the U.S. where they are
well known and exchange dollars for pounds.
◦ This will give them exchange rate risk: financing a
sterling project with dollars.
 They could borrow pounds in the international bond
market, but pay a premium since they are not as well
known abroad.

25-43
 If they can find a British MNC with a mirror-image
financing need they may both benefit from a swap.
 If the spot exchange rate is S0($/£) = $1.60/£, the U.S.

firm needs to find a British firm wanting to finance
dollar borrowing in the amount of $16,000,000.

25-44
Consider two firms A and B: firm A is a U.S.–based
multinational and firm B is a U.K.–based
multinational.
Both firms wish to finance a project in each other’s

country of the same size. Their borrowing
opportunities are given in the table below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%

25-45
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
$ £
Company B 10.0% 12.0%

25-46
A’s net position is to borrow at £11%
Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A B
A saves £.6%
$ £
Company B 10.0% 12.0%

25-47
B’s net position is to borrow at $9.4%

Swap
Bank
$8% $9.4%
£11% £12%
$8% Firm Firm £12%
A $ £ B
Company B 10.0% 12.0% B saves $.6%

25-48
The swap bank makes money too: 1.4% of $16 million
Swap financed with 1% of
£10 million per year
Bank
$8% $9.4%
for 5 years.
£11% £12%
$8% Firm At S0($/£) = $1.60/£, that Firm £12%
A is a gain of $64,000 per B
year for 5 years. The swap bank
$ £
Company A 8.0% 11.6% faces exchange rate
Company B 10.0% 12.0%
risk, but maybe
they can lay it off
(in another swap).
25-49
Credit Default Swaps
 Counterparty # 1 (protection buyer) makes a periodic

payment (CDS spread) to counterparty #2 (protection
seller).
 In exchange, counterparty #2 agrees to pay for a
particular bond issue should a default occur.
 Historically, these contracts were traded on a
customized basis. The lack of an exchange creates
counterparty risk.

25-50
Variations of Basic Swaps
 Currency Swaps
◦ fixed for fixed
◦ fixed for floating
◦ floating for floating
◦ amortizing
 Interest Rate Swaps
◦ zero-for floating
◦ floating for floating
 Exotics
◦ For a swap to be possible, two humans must like the idea.
Beyond that, creativity is the only limit.
25-51
Risks of Interest Rate and Currency Swaps
 Interest Rate Risk
◦ Interest rates might move against the swap bank after it has
only gotten half of a swap on the books, or if it has an
unhedged position.
 Basis Risk
◦ Occurs if the floating rates of the two counterparties are not
pegged to the same index
 Exchange Rate Risk
◦ In the example of a currency swap given earlier, the swap
bank would be worse off if the pound appreciated.

25-52
Risks of Interest Rate and Currency Swaps
 Credit Risk
◦ This is the major risk faced by a swap dealer—the risk that
a counterparty will default on its end of the swap.
 Mismatch Risk
◦ It is hard to find a counterparty that wants to borrow the
right amount of money for the right amount of time.
 Sovereign Risk
◦ The risk that a country will impose exchange rate
restrictions that will interfere with performance on the
swap.

25-53
Pricing a Swap
 A swap is a derivative security, so it can be priced in
terms of the underlying assets:
◦ Plain vanilla fixed for floating swap gets valued just like a
bond.
◦ Currency swap gets valued just like a nest of currency
futures.

25-54
25.8 Actual Use of Derivatives
 Because derivatives do not appear on the balance
sheet, they present a challenge to financial
economists who wish to observe their use.
 Survey results appear to support the notion of
widespread use of derivatives among large publicly
traded firms.
 Foreign currency and interest rate derivatives are the
most frequently used.

25-55
Quick Quiz
 Explain the differences between forward and futures
contracts.
 Explain the process of valuing a futures contract.
 Explain why/how corporations would use futures

contracts.

25-56

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Chapter

25 Derivatives and Hedging Risk

 Understand the basics of forward and futures

 Understand how derivatives can be used to hedge

Copyright © 2016 McGraw-Hill Education. All rights reserved.

25.1 Derivatives, Hedging, and Risk

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

 A futures contract is like a forward contract:

 A futures contract is different from a forward:

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

TREASURY BONDS (CBT) - $1,000,000; pts. 32nds of 100%

 Open interest is a good proxy for the demand for a

 Some refer to open interest as the depth of the

Copyright © 2016 McGraw-Hill Education. All rights reserved.

If futures prices rise by 5 cents, you will gain:

If prices decrease by 5 cents, your loss is:

Copyright © 2016 McGraw-Hill Education. All rights reserved.

 Pricing of Forward Contracts

 Hedging in Interest Rate Futures

Copyright © 2016 McGraw-Hill Education. All rights reserved.

CF1 0 NPV 881.86

 The only real difference is the daily resettlement.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

 Duration is the key to measuring interest rate risk.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

PV (C1 )  1 PV (C2 )  2 L  PV (CT )  T

Calculate the duration of a three-year bond that

Copyright © 2016 McGraw-Hill Education. All rights reserved.

0.5 $40.00 0.96154 $38.46 0.0192

 Zero coupon bond: duration = maturity

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

The borrowing opportunities of the two firms are:

Fixed rate 11.75% 10%

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Copyright © 2016 McGraw-Hill Education. All rights reserved.

Bank LIBOR – ½ %, which is ½ %

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LIBOR + ½ % and have a net LIBOR – ¼%

LIBOR – 1/8% LIBOR – ¼%

LIBOR – 1/8% LIBOR – ¼%

Copyright © 2016 McGraw-Hill Education. All rights reserved.

 If the spot exchange rate is S0($/£) = $1.60/£, the U.S.

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Both firms wish to finance a project in each other’s

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

Copyright © 2016 McGraw-Hill Education. All rights reserved.

B’s net position is to borrow at $9.4%