1 CHAPTER 25 Derivatives and Hedging Risk McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights Chapter Outline 25.1 Forward Contracts 25.2 Futures Contracts 25.3 Hedging 25.4 Interest Rate Futures Contracts 25.5 Duration Hedging 25.6 Swap Contracts 25.7 Actual Use of Derivatives 25.8 Summary & Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 25.1 Forward Contracts A forward contract specifies that a certain commodity will be exchanged for another at a specified time in the future at prices 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 25.2 Futures Contracts: Preliminaries A futures contract is like a forward contract: It specifies that a certain commodity will be exchanged for another at a specified time in the future at prices 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights Futures Contracts: Preliminaries Standardizing Features: Contract Size Delivery Month Daily resettlement Minimizes the chance of default Initial Margin About 4% of contract value, cash or T-bills held in a street name at your brokerage McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights Daily Resettlement: An Example Suppose you want to speculate on a rise in the $/¥ exchange rate (specifically you think that the dollar will appreciate) Japan (yen) 1-month forward 3-months forward 6-months forward U.S $ equivalent Wed Tue 0.007142857 0.007194245 0.006993007 0.007042254 0.006666667 0.006711409 0.00625 0.006289308 Currency per U.S $ Wed Tue 140 139 143 142 150 149 160 159 Currently $1 = ¥140 The 3-month forward price is $1=¥150 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights Daily Resettlement: An Example 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 make money 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 ì Ơ12,500,000 ì Ơ150 McGraw-Hill/Irwin Corporate Finance, 7/e â 2005 The McGraw-Hill Companies, Inc All Rights Daily Resettlement: An Example If tomorrow, the futures rate closes at $1 = ¥149, then your position’s value drops Your original agreement was to sell ¥12,500,000 and receive $83,333.33: $1 $83,333.33 = ¥12,500,000 × ¥150 But ¥12,500,000 is now worth $83,892.62: $1 $83,892.62 = Ơ12,500,000 ì Ơ149 You have lost $559.28 overnight McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights Daily Resettlement: An Example The $559.28 comes out of your $3,333.33 margin account, leaving $2,774.05 This is short of the $3,355.70 required for a new position $1 $3,355.70 = 0.04 ì Ơ12,500,000 ì Ơ149 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 10 Selected Futures Contracts Contract Agricultural Contract Size Exchange Corn Wheat Cocoa OJ Metals & Petroleum Copper Gold Unleaded gasoline Financial British Pound Japanese Yen Eurodollar 5,000 bushels 5,000 bushels 10 metric tons 15,000 lbs Chicago BOT Chicago & KC CSCE CTN McGraw-Hill/Irwin Corporate Finance, 7/e 25,000 lbs 100 troy oz 42,000 gal CMX CMX NYM £62,500 ¥12.5 million $1 million IMM IMM LIFFE © 2005 The McGraw-Hill Companies, Inc All Rights 42 An Example of an Interest Rate Swap The swap bank makes money too ¼% of $10 million = $25,000 per year for years Swap 10 3/8% Bank 10 ½% LIBOR – 1/8% Bank LIBOR – ¼% LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8 A Company 10 ½ - 10 3/8 = 1/8 B ¼ COMPANY Fixed rate Floating rate McGraw-Hill/Irwin Corporate Finance, 7/e B BANK A 11.75% 10% LIBOR + 5% LIBOR © 2005 The McGraw-Hill Companies, Inc All Rights 43 An Example of an Interest Rate Swap The swap bank makes ¼% Swap 10 3/8% Bank 10 ½% LIBOR – 1/8% LIBOR ẳ% Bank Company A A saves ẵ% B Fixed rate Floating rate McGraw-Hill/Irwin Corporate Finance, 7/e B saves ½% COMPANY B BANK A 11.75% 10% LIBOR + 5% LIBOR © 2005 The McGraw-Hill Companies, Inc All Rights 44 An Example of a Currency Swap Suppose a U.S MNC wants to finance a £10,000,000 expansion of a British plant They could borrow dollars in the U.S where they are well known and exchange for dollars for pounds This will give them exchange rate risk: financing a sterling project with dollars They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 45 An Example of a Currency Swap If they can find a British MNC with a mirrorimage financing need they may both benefit from a swap If the spot exchange rate is S0($/£) = $1.60/£, the U.S firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16,000,000 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 46 An Example of a Currency Swap 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 McGraw-Hill/Irwin Corporate Finance, 7/e $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% © 2005 The McGraw-Hill Companies, Inc All Rights 47 An Example of a Currency Swap Swap Bank $8% $9.4% £11% $8% £12% Firm Firm A B McGraw-Hill/Irwin Corporate Finance, 7/e $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% £12% © 2005 The McGraw-Hill Companies, Inc All Rights 48 An Example of a Currency Swap A’s net position is to borrow at £11% Swap Bank $8% $9.4% £11% $8% £12% Firm Firm A B McGraw-Hill/Irwin Corporate Finance, 7/e A saves £.6% $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% £12% © 2005 The McGraw-Hill Companies, Inc All Rights 49 An Example of a Currency Swap B’s net position is to borrow at $9.4% Swap Bank $8% $9.4% £11% $8% £12% Firm Firm A B McGraw-Hill/Irwin Corporate Finance, 7/e $ £ Company A 8.0% 11.6% Company B 10.0% 12.0% £12% B saves $.6% © 2005 The McGraw-Hill Companies, Inc All Rights 50 An Example of a Currency Swap The swap bank makes money too: 1.4% of $16 million financed with 1% of £10 million per year for years Swap Bank $8% $9.4% £11% $8% Firm A £12% Firm £12% At S0($/£) = $1.60/£, that is a gain of $64,000 per B year for years The swap bank faces $ Company A Company B McGraw-Hill/Irwin Corporate Finance, 7/e £ exchange rate risk, but 8.0% 11.6% maybe they can lay it 10.0% 12.0% off (in another swap) © 2005 The McGraw-Hill Companies, Inc All Rights 51 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 Exotica For a swap to be possible, two humans must like the idea Beyond that, creativity is the only limit McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 52 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 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 53 Risks of Interest Rate and Currency Swaps Credit Risk This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap Mismatch Risk It’s 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 54 Pricing a Swap A swap is a derivative security so it can be priced in terms of the underlying assets: How to: Plain vanilla fixed for floating swap gets valued just like a bond Currency swap gets valued just like a nest of currency futures McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 55 25.7 Actual Use of Derivatives Because derivatives don’t appear on the balance sheet, they are present a challenge to financial economists who which 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 McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 56 25.8 Summary & Conclusions This chapter shows a number of hedging strategies A short hedge involves an agreement to sell the underlying asset in the future A long hedge involves an agreement to buy the underlying asset in the future Swaps can also be used to hedge; a swap can be viewed as a portfolio of futures with different maturities McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights ... Swap Contracts 25.7 Actual Use of Derivatives 25.8 Summary & Conclusions McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 25.1 Forward Contracts A forward... textbook that was not in stock, you have entered into a forward contract McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights 25.2 Futures Contracts: Preliminaries... exchanges with daily resettlement (“marking to market”) through a clearinghouse McGraw-Hill/Irwin Corporate Finance, 7/e © 2005 The McGraw-Hill Companies, Inc All Rights Futures Contracts: Preliminaries