Chapter 24 Appendix 1 More on Hedging with Financial Derivatives
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-1 Hedging with Financial Futures Micro-hedge – hedge the interest-rate risk of a single asset. Macro-hedge – hedge the interest-rate risk of the overall portfolio, or firm.
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-2 Micro Hedge Example First National Bank holds $10 million in 10% T-bonds, maturing in Will use exchange-traded futures contract to hedge risk. Short position. But how many contracts? No perfect match in futures market.
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-3 Micro Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-4 Micro Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-5 Micro Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-6 Micro Hedge Example (a)
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-7 Micro Hedge Example (b)
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-8 Micro Hedge Example (c)
Copyright ©2015 Pearson Education, Inc. All rights reserved.24-9 Micro Hedge Example (d)
Copyright ©2015 Pearson Education, Inc. All rights reserved Macro Hedge Example First National Bank holds $100 million in assets with a duration gap of 1.72 years. Will use exchange-traded futures contract to hedge risk. Short position. But how many contracts? No perfect match in futures market.
Copyright ©2015 Pearson Education, Inc. All rights reserved Macro Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved Macro Hedge Example (a)
Copyright ©2015 Pearson Education, Inc. All rights reserved Macro Hedge Example (b)
Copyright ©2015 Pearson Education, Inc. All rights reserved Futures Options Hedge Example First National Bank has a $2 million, 7%, four year loan commitment that expires in two months Will use exchange-traded futures options contract to hedge risk. Long put option on T-note futures. But how many contracts? Not a perfect match.
Copyright ©2015 Pearson Education, Inc. All rights reserved Futures Options Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved Futures Options Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved Futures Options Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved Futures Options Hedge Example (a)
Copyright ©2015 Pearson Education, Inc. All rights reserved Futures Options Hedge Example (b)
Copyright ©2015 Pearson Education, Inc. All rights reserved Futures Options Hedge Example (c)
Copyright ©2015 Pearson Education, Inc. All rights reserved Interest-Rate Swaps Hedge Example First National Bank holds $32 million and $49.5 million in rate-sensitive assets and liabilities, respectively. Use 10-year interest rate swap to hedge. ─ Receive 1% + 1-yr T-bill rate ─ Pay fixed 7% What notional amount should be swapped?
Copyright ©2015 Pearson Education, Inc. All rights reserved Interest-Rate Swaps Hedge Example
Copyright ©2015 Pearson Education, Inc. All rights reserved Interest-Rate Swaps Hedge Example (a)
Copyright ©2015 Pearson Education, Inc. All rights reserved Macro Hedge Example (b)
Copyright ©2015 Pearson Education, Inc. All rights reserved Stock Index Futures Stock index futures can be used to hedge two situations: ─ Reduce systematic risk ─ Lock in stock prices
Copyright ©2015 Pearson Education, Inc. All rights reserved Stock Index Futures Reducing Systematic Risk Systematic risk – sensitivity of portfolio to changes in entire market Measured with beta (β) ─ β = 0.5 means portfolio will increase 1% when the market increases 2%.
Copyright ©2015 Pearson Education, Inc. All rights reserved Hedging with Stock Index Futures: Example Rock Solid stock portfolio of $100 million β of portfolio is 1.0 Wants to reduce beta to zero using futures Stock futures index contracts selling for $1,000, contract size = $250,000
Copyright ©2015 Pearson Education, Inc. All rights reserved Hedging with Stock Index Futures: Example Must sell $100 million worth of futures, or $100 million / $250,000 = 400 contracts Market down 10%? ─ Portfolio falls to $90 million ─ Futures price falls $25,000 / contract, or a gain to Rock Solid of $25,000 x 400 = $10 million
Copyright ©2015 Pearson Education, Inc. All rights reserved Hedging with Stock Index Futures
Copyright ©2015 Pearson Education, Inc. All rights reserved Hedging with Stock Index Futures: Example (a)
Copyright ©2015 Pearson Education, Inc. All rights reserved Hedging with Stock Index Futures: Example (b)
Copyright ©2015 Pearson Education, Inc. All rights reserved Stock Index Futures Locking in Stock Prices Can lock-in prices of market level today. Useful in situations where cash to buy a position is on the way.
Copyright ©2015 Pearson Education, Inc. All rights reserved Stock Index Futures Locking in Stock Prices: Example Today is January 1 Rock Solid expects to receive insurance premiums of $20 million in March March futures price is $1,000. Manger forecasts price to rise 5% by March Can lock-in price today!
Copyright ©2015 Pearson Education, Inc. All rights reserved Stock Index Futures Locking in Stock Prices: Example Long position on 80 contracts ─ 80 = $20 million / $250,000 Market up 5% ─ Gain of $12,500 per contract, or $1 million!