Transcript Chapter 17: Managing Interest Rate Risk

Chapter 18
Managing Financial Risk with
Derivatives
Order
Placed
Order
Received
< Inventory >
Sale
Payment Sent Cash
Received
Accounts
Collection
< Receivable > < Float >
Time ==>
Accounts
< Payable >
Invoice Received
Disbursement
<
Float
>
Payment Sent
Cash Disbursed
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Learning Objectives
 Understand
the basic difference between
hedging and speculating.
 Discern between hedging instruments
including futures, options, swaps, and
products such as interest rate ceiling, floor,
and collars.
 Develop appropriate interest rate hedging
strategies.
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Hedging vs. Speculating
 A hedger
has a cash position or an
anticipated cash position that he or she is
trying to protect from adverse interest rate
movements
 A speculator
has no operating cash flow
position to protect and is trying to profit
solely from interest rate movements
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Some Important Terms
 Hedger
 Speculator
 Perfect
vs imperfect hedge
 Pure vs anticipatory hedge
 Partial and cross hedge
 Long (buy) and short (sell) hedge
 Mark to market
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Hedger
An entity who uses the futures market to offset the price risks
associated with his basic business activities. By assuming a
position in the futures market that is equal and opposite to his
position in the cash market, the hedger established a situation
where losses in the cash market are offset by gains in the
futures market and vice versa.
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Speculator
An entity who takes a position in the futures market
that is not offset by an opposite position in a basic line
of business.
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Perfect vs Imperfect Hedge
A perfect hedge is one where the individual is able to
eliminate all risk of price fluctuations.
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Pure vs Anticipatory Hedge
A pure hedge is one where the individual assumes a position in
the futures market equal and opposite to the current position
in the cash market (such as hedging a riding the yield curve
position).
An anticipatory hedge is taking a position that is a temporary
substitute for an anticipated position in the cash market.
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Partial and Cross Hedge
A partial hedge is where the person takes a position in the
futures market that is smaller than the cash position.
A cross hedge is where the manager uses a different hedging
instrument (futures instrument) than the hedged cash
instrument.
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Long (buy) and Short (sell) Hedge
A long hedge is where the firm BUYS a futures contract.
A short hedge is where the firm SELLS a futures contract.
A long hedge is appropriate when the firm will buy an asset in
the future or sell a liability prior to maturity.
A short hedge is appropriate when the firm issues a liability
in the future or sells a current cash position in the future.
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Mark to Market
Everyday the gain or loss on a futures position causes your
margin account to be adjusted, gains or credited to your
account and losses or debited.
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Hedging With Financial Futures
 Introduction
 Buy
vs. sell hedge
 Choosing the instrument
 Choosing the expiration date
 Choosing the number of contracts
 Performance evaluation
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Introduction to Hedging w/Futures
A standardized contract that carries with it a
performance obligation at expiration
 Margin is generally required and is marked-tomarket daily
 WSJ Quotes
Eurodollar (CME) - $1 mil.; pts of 100%

Open
Open High Low Settle Chg Yield Chg Interest
Mar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463
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Buy vs. Sell Hedge
 Type
of hedge should depend on the nature
of the cash flow position being hedged, not
on the anticipated direction of interest
rates.
 Buy Hedge: A future investment or retiring
a liability prior to maturity
 Sell Hedge: Issue a liability in the future or
sell an investment prior to its maturity
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Choosing the Instrument
 Choice
of instrument should be
consistent with the nature of the cash
flow being hedged.
 The
interest rates should be highly
correlated.
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Choosing the Expiration Date
 Choose
the contract expiration month
that occurs nearest to, but after, the date
of the cash market transaction to be
hedged.
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Choosing the Number of Contracts
Size of cash market instrument
Maturity of cash market instrument
N = ----------------------------------------- x ----------------------------------------------Futures contract denomination
Maturity of futures contract instr.
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Performance Evaluation - Interest
Rate Futures Hedge

Change in the value of the cash position
Face value cash x (SR0 - SR1) x (Matc/360)

Change in the value of the futures position
Face value futures x (FR0 - FR1) x Matf/360)

Commission cost
Number of contracts x Commission rate

Opportunity cost of the margin
Number of contracts x MRG x (D x k/360)
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Performance Evaluation -Currency
Futures Hedge

Change in the value of the spot market position
Face value cash x (CX0 - CX1) = Gain (loss) spot

Change in the value of the futures position
Face value futures x (FX0 - FX1) = Gain (loss)
futures

Commission cost
# contracts x Commission rate = Commission cost

Opportunity cost of the margin
# contracts x MRG x D x (k/360) = Margin cost
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Why Hedges Are Not Perfect
 Futures
contracts in general have only four
expiration dates per year. (Note T-bills:
Mar, June, Sept, and Dec.
 Correlation
coefficient of spot rates and
futures rates is less than 1.0
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Hedging With Options
 Introduction
 Type
of hedge: write or purchase, call or
put
 Number of contracts
 Performance evaluation
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Introduction to Options
 A call
option contract gives the buyer the
“right” to purchase the underlying asset at
a specific price, the striking price, over a
specific span of time. The buyer pays a
premium for this right.
 A put option allows the owner to sell the
underlying asset at a specific price over a
specific span of time. The buyer pays a
premium for this right.
 The options are on futures contracts for
interest rate instruments
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Type of Hedge: Write or Purchase,
Call or Put
 Purchase
a call futures option to hedge a future
investment of cash or retire a liability before
maturity.
 Purchase a put futures option to hedge the
future issue of liabilities or the future
liquidation of financial assets.
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Number of Contracts
 The
number of options needed to purchase
is based directly on the number of futures
contracts needed. Refer to Equation 18-1.
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Hedging With Swaps
 Introduction
 Interest
rate swaps
– Liability swap
– Asset swap
 Foreign
currency swap
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Introduction
An interest rate swap occurs when two parties agree to
exchange cash flow streams for a specified period of
time. Swaps are different from options and futures in
that they are not generally standardized and their
maturities are usually for longer time periods than
maturities of options and futures.
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Introduction to Swaps, continued
Interest rate swaps were created to take advantage of arbitrage
opportunities in the various fixed- and floating-rate capital
markets. Arbitrage opportunities exist because some markets
react to change more rapidly than others, because credit
perceptions differ from market to market, and because
receptivity to specific debt structures differs from market to
market. If, for instance, a corporation wants term floating-rate
funds but finds that the market for its fixed-rate debt is comparatively cheaper than that for its floating-rate debt, then it
can issue a fixed-rate bond and swap it into floating, for an
all-in cost lower than that for a floating-rate bond or loan.
Source: The Government Securities Pink Book
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Other Details about Swaps
 Notional Amount:
the base on which all
interest payments are computed. This amount
generally exceeds $25 million.
 Risks: if the counterparty defaults
 Direct Swap: an agreement between two
parties without the involvement of a financial
intermediary
 Indirect Swap: the agreement is executed
through an intermediary which may assume
some of the credit risk.
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Interest Rate Swap Diagram
(Fixed-for-Floating Liability Swap)
Borrows floating rate
debt but desires
$
fixed rate debt
Floating Rate Interest Payments
$
$
$
$
Pays off floating rate
$ debt principal at
maturity
. . . . . . .
Counterparty A
Counterparty A
A pays out fixed rate
to B
$
$
$
$
$
$
$
$
$
$
$
$
B pays out
floating rate to A
. . . . . . .
Counterparty B
Borrows fixed rate
debt but desires
floating rate debt
$
Counterparty B
$
$
$
$
Fixed Rate Interest Payments
$
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Pays off fixed rate
debt principal at
maturity
2005
by Thomson Learning, Inc.
Liability Swap
 k swap
= fr + so - si + fee
fr = financing rate
so = swap outflow
si = swap inflow
fee = intermediary fee
 If
fr is fixed rate then so is floating and si is
fixed
If fr is floating then so is fixed and si is floating
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Asset Swap
 k swap
= ir - so + si - fee
ir = investment return
so = swap outflow
si = swap inflow
fee = intermediary fee
 If
ir is floating rate then so is floating and si is
fixed
If ir is fixed rate then so is fixed and si is
floating
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A Currency Swap Diagram
Dollar Interest Payments
Borrows pounds
sterling but swaps
for dollars
Re-exchanges $ for
pounds sterling and
pays off debt
. . . . . . .
U. K. Company
U. K. Company
$
£
$
£
$
£
$
£
$
£
$
£
$
£
U. S. Company
Borrows dollars
and swaps for
pounds sterling
$
£
. . . . . . .
U. S. Company
Pound Sterling Interest Payments
Re-exchange £ for
dollars and pays off
debt
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Other Hedging Instruments

Interest rate caps
– Purchaser pays a premium and receives cash payments from
the cap seller when the reference rate exceeds strike rate.
– Cap payment = (ref - strk) x NP x L

Interest rate floors
– Purchaser pays a premium for the rate floor contract, receives
cash payment when reference rate falls below strike rate.
– Floor payment = (strk - ref) x NP x L

Interest rate collars
– Purchase a rate cap and sell or issue a rate floor. Pay a
premium for the cap and receive a premium for the floor.
[Floor payment - Cap payment]
– Effective rate = REF + ----------------------------------------NP
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Summary
 The
chapter began by discussing the difference
between hedging and speculating.
 The characteristics of different types of
derivative instruments were presented.
 Hedging strategies for each instrument were
developed.
 Each section concluded with a section on how
to evaluate the performance of the hedge.
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