hedging with financial derivatives

Hedge - engage in a financial transaction that reduces or eliminates risk Long position - taking a position associated with the purchase of an asset Short position – taking a position associated with the sale of an asset

Copyright 2011  Pearson Canada Inc. 14 - 1 Chapter 14 Hedging with Financial Derivatives Copyright 2011  Pearson Canada Inc. 14 - 2 Hedging I Hedge - engage in a financial transaction that reduces or eliminates risk Long position - taking a position associated with the purchase of an asset Short position – taking a position associated with the sale of an asset Copyright 2011  Pearson Canada Inc. 14 - 3 Hedging II Basic hedging principle: Hedging risk involves engaging in a financial transaction that offsets a long position by taking a additional short position, or offsets a short position by taking a additional long position Copyright 2011  Pearson Canada Inc. 14 - 4 Forward Contracts and Markets • A forward contract is an agreement between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now. • Forward contracts are traded over-the-counter (OTC) • Two types discussed: – Interest-rate forward contracts – Forward contracts for foreign currencies Copyright 2011  Pearson Canada Inc. 14 - 5 Interest Rate Forward Contracts • An interest rate forward contract involves the future sale (purchase) of a debt instrument • Contract specifies -Specification of the debt instrument - Amount of the instrument to be delivered - The price (interest rate) on the instrument when it is delivered - The date when delivery takes place Copyright 2011  Pearson Canada Inc. 14 - 6 Interest-Rate Forward Markets I • Long position = agree to buy securities at future date • Hedges by locking in future interest rate if funds coming in future • Short position = agree to sell securities at future date • Hedges by reducing price risk from change in interest rates if holding bonds Copyright 2011  Pearson Canada Inc. 14 - 7 Interest-Rate Forward Markets II Pros 1. Flexible (can be used to hedge completely the interest rate risk) Cons 1. Lack of liquidity: hard to find a counterparty to make a contract with 2. Subject to default risk: requires information to screen good from bad risk Copyright 2011  Pearson Canada Inc. 14 - 8 Financial Futures Markets Financial futures are classified as • Interest-rate futures • Stock index futures, and • Currency futures Copyright 2011  Pearson Canada Inc. 14 - 9 Interest Rate Features Copyright 2011  Pearson Canada Inc. 14 - 10 Interest Rate Futures Markets I Interest Rate Futures Contract 1. Specifies delivery of type of security at future date 2. Arbitrage ⇒ at expiration date, price of contract = price of the underlying asset delivered 3. i ↑, long contract has loss, short contract has profit 4. Hedging similar to forwards [...]... is referred to as arbitrage • A micro hedge occurs when the institution is hedging the interest rate for a specific asset it is holding • A macro hedge is when the hedge is for the entire portfolio Financial Futures Markets • Organization and Trading – CBOT, Chicago Mercantile Exchange, Montreal Exchange, London International Financial futures Exchange, Marché à Terme International de France – Open... exercised any time up to the expiration date 2 European options that can be exercised only on the expiration date • Stock options • Financial futures options (futures options) The Payoff from Buying a Call To understand calls, let's assume that you hold a European call on an asset with an exercise price of X and a call premium of α • If at the expiration date, the price of the underlying asset, S, is less... expiration with asset price S (at that time) and exercise price X is C = max (0, S - X) In other words, the value of a call option (intrinsic value) at maturity is S - X, or zero, whichever is greater • If S > X, the call is said to be in the money, and the owner will exercise it for a net profit of C - α • If S < X, the call is said to be out of the money and will expire worthless • A call with S =... put is the mirror image of that from buying a put As with writing a call, the writer of a put receives the put premium, β, up front and must sell the asset underlying the option if the buyer of the put exercises the option to sell Profits From Buying and Writing a Put Option Summary In general, the value of a put option, P, at the expiration date with exercise price X and asset price S (at that time)... Futures more liquid: standardized, can be traded again, delivery of range of securities Delivery of range of securities prevents corner ark to market: avoids default risk Don’t have to deliver: netting Financial Futures Contracts in the U.S Stock Index Futures Contracts I • Stock index futures were designed to manage stock market risk and are now among the most widely traded of all futures contracts... quoted in terms of index points – Change of 1 point represents a change of $250 in the contract’s value Stock Index Futures Contracts II • Stock index future contracts differ form most other types of financial futures contracts in that they are settled in cash delivery rather than delivery of a security • Cash settlement gives a high degree of liquidity • For a S&P 500 Index, contract, at the final... in a put • The buyer of a put option will have to pay a premium (called the put premium) in order to get the writer to sign the contract and assume the risk The Payoff from Buying a Put Consider a put with an exercise price of X and a premium of β • At a price of X or higher, the put will not be exercised, resulting in a loss of the premium • At a price below X - β, the put will yield a net profit •... the seller receive this amount from the buyer Options I • A call option is an option that gives the owner the right (but not the obligation) to buy an asset at a pre specified exercise (or strike) price within a specified period of time • Since a call represents an option to buy, the purchase of a call is undertaken if the price of the underlying asset is expected to go up Options II • The buyer of a... Greater term to expiration higher premiums for both call and put options 3 Greater price volatility of underlying instrument higher premiums for both call and put options Interest Rate Swaps I • Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments it owns for another set of payments owned by another party • Two kinds of swaps – currency swaps and interest-rate