© 2008 Pearson Education Canada13.1 Chapter 13 Hedging with Financial Derivatives

© 2008 Pearson Education Canada13.2Hedging 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

© 2008 Pearson Education Canada13.3 Hedging (Cont’d) 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

© 2008 Pearson Education Canada13.4 Forward Markets A forward contract is an agreement (at time 0) between a buyer and a seller that an asset will be exchanged for cash at some later date at a price agreed upon now

© 2008 Pearson Education Canada13.5 Interest Rate Forward Contracts An interest rate forward contract involves the future sale (purchase) of a debt instrument and has several dimensions: 1.Specification of the debt instrument 2.Amount of the instrument to be delivered

© 2008 Pearson Education Canada The price (interest rate) on the instrument when it is delivered 4. The date when delivery takes place

© 2008 Pearson Education Canada13.7 Interest-Rate Forward Markets 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

© 2008 Pearson Education Canada13.8 Interest-Rate Forward Markets (Cont’d) 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

© 2008 Pearson Education Canada13.9 Financial Futures Markets Financial futures are classified as Interest-rate futures Stock index futures, and Currency futures

© 2008 Pearson Education Canada13.10 Interest Rate Futures Markets (Cont’d) 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

© 2008 Pearson Education Canada13.11 Interest Rate Futures Markets (Cont’d) At the expiration date of a futures contract, the price of the contract is the same as the price of the underlying asset to be delivered The elimination of riskless profit opportunities in the futures market is referred to as arbitrage

© 2008 Pearson Education Canada13.12 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

© 2008 Pearson Education Canada13.13 Interest Rate Futures Markets Success of Futures Over Forwards 1.Futures more liquid: standardized, can be traded again, delivery of range of securities 2.Delivery of range of securities prevents corner 3.Mark to market: avoids default risk 4.Don’t have to deliver: netting

© 2008 Pearson Education Canada13.14 Stock Index Futures Contracts Stock index futures were designed to manage stock market risk and are now among the most widely traded of all futures contracts The S&P Index measures the value of 500 of the most widely traded stocks in the United States

© 2008 Pearson Education Canada13.15 Stock Index Futures Contracts (Cont’d) 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

© 2008 Pearson Education Canada13.16 Cash settlement gives a high degree of liquidity For a S&P 500 Index, contract, at the final settlement date, the cash delivery due is $250 times the Index

© 2008 Pearson Education Canada13.17 Stock Index Futures Contracts (Cont’d) If the Index is 1000 on the settlement date, $ is the amount due. The price quotes for the contract are also quoted in terms of index points, so a change of one point represents a change of $250 in the contract’s value

© 2008 Pearson Education Canada13.18 Options 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.

© 2008 Pearson Education Canada13.19 The buyer of a call is said to be long in a call and the writer is said to be short in a call. The buyer of a call will have to pay a premium in order to get the writer to sign the contract and assume the risk.

© 2008 Pearson Education Canada13.20 Options (Cont’d) There are two types of option contracts: 1. American options that can be exercised any time up to the expiration date 2.European options that can be exercised only on the expiration date

© 2008 Pearson Education Canada13.21 The Payoff from Writing a Call The payoff function from writing the call option is the mirror image of the payoff function from buying the call.

© 2008 Pearson Education Canada13.22 Buying and Writing Puts A second type of option contract is the put option. It gives the owner the right (but not the obligation) to sell an asset to the option writer at a pre specified exercise price. As a put represents an option to sell rather than buy, it is worth buying a put when the price of the underlying asset is expected to fall.

© 2008 Pearson Education Canada13.23 As with calls, the owner of a put is said to be long in a put and the writer of a put is said to be short in a put. Also, as with calls, 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.

© 2008 Pearson Education Canada13.24 The Payoff from Writing a Put The payoff function from writing a put is the mirror image of that from buying a put.

© 2008 Pearson Education Canada13.25 Interest Rate Swaps Interest-rate swaps involve the exchange of one set of interest payments for another set of interest payments, all denominated in the same currency

© 2008 Pearson Education Canada13.26 Interest Rate Swaps (Cont’d)

© 2008 Pearson Education Canada13.27 Advantages of Interest Rate Swaps Advantages of interest rate swaps 1.Reduce risk, no change in balance-sheet 2.Longer term than futures or options Disadvantages of interest rate swaps 1.Lack of liquidity 2.Subject to default risk

© 2008 Pearson Education Canada13.28 Financial intermediaries help reduce disadvantages of swaps