Chapter 24 Fundamentals of Corporate Finance Fifth Edition Slides by Matthew Will McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved Risk Management

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Topics Covered  Why Hedge?  Reducing Risk with Options  Futures Contracts  Forward Contracts  Swaps  Innovation in the Derivatives Market  Is “Derivative” a Four-Letter Word?

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Why Hedge?  Question of The Day  What is a cereal company in the business of doing? A. Producing a product efficiently and selling it for a profit. B. Speculating on the price of sugar, wheat, and other inputs to its product. Answer: Both

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Why Hedge?  Question of The Day  The company does A. by choice and B. because it has no choice.  The company can eliminate B through Hedging

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Reducing Risk With Options Example - Onnex sells crude oil. Since its costs are relatively fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses. How might Onnex hedge this risk?

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Reducing Risk With Options Example - Onnex sells crude oil. Since its costs are relatively fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses. How might Onnex hedge this risk? Price per barrel Onnex’s loses money when prices drop. Revenues

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Reducing Risk With Options Example - Onnex sells crude oil. Since its costs are relatively fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses. How might Onnex hedge this risk? Price per barrel A put option makes money when prices drop. Revenues

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Reducing Risk With Options Example - Onnex sells crude oil. Since its costs are relatively fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses. How might Onnex hedge this risk? Price per barrel Onnex’s natural risk, plus a put option provides a HEDGE against price declines. Revenues

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Futures Contracts Futures Contract - Exchange traded forward contract with gains or losses realized daily. Profit to seller = initial futures price - ultimate market price Profit to buyer = ultimate market price - initial futures price

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Future Contracts Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market. Show the positions involved in this hedge.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Future Contracts The farmer loses money when the price drops Price per bushel Value of wheat Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market. Show the positions involved in this hedge.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Future Contracts Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market. Show the positions involved in this hedge. The futures contract profits when prices drop Price per bushel Value of wheat

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Future Contracts Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market. Show the positions involved in this hedge. With a futures contract the farmer locks in a price Price per bushel Value of wheat

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Financial Futures Goal (Hedge) - To create an exactly opposite reaction in price changes, from your cash position. Commodities - Simple because assets types are finite. Financials - Difficult because assets types are infinite.  You must attempt to approximate your position with futures via “Hedge Ratios.”

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Financial Futures

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Forward Contracts Forward Contract - Agreement to buy or sell an asset in the future at an agreed price.  Forward contracts are “custom designed” futures contracts. They have specific amounts and expiration dates to meet the buyers’ needs.

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Swaps Swap - Arrangement by two counterparties to exchange one stream of cash flows for another. CompanySwap Dealer Fixed rate pmt LIBOR pmt

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Example - Interest Rate Swaps Available LoansAaa Corp Baa Corp Fixed Rate Loan10%11.5% Variable Rate Loan7.25%7.50% Swap Aaa Corp Borrows $1mil fixed 10% BAA Corp Borrows $1mil variable 7.5% Aaa assumes pmts on variable 7.5% Baa assumes pmts on fixed 10.75%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Aaa Benefit Pay Get Pay 7.50% Var 7.25% Net Benefit+.50% Available LoansAaa Corp Baa Corp Fixed Rate Loan10%11.5% Variable Rate Loan7.25%7.50% Example - Interest Rate Swaps

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Aaa BenefitBaa Benefit Pay 7.50% Get 7.50% Pay 7.50%Pay Var 7.25%Fix Net Benefit+.50%Net Benefit+.75% Available LoansAaa Corp Baa Corp Fixed Rate Loan10%11.5% Variable Rate Loan7.25%7.50% Example - Interest Rate Swaps

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Currency Swaps Similar to interest rate swaps Same type loan, just diff currency WHY? example: you have an investment in Japan Project is financed with US bonds You look for SWAP partner so you can emulate holding Japanese bonds JavaYahooprincipal Yen loan11%12%$ 1 mil $ loan8%11.1%or Y120

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Currency Swaps example - cont Java borrows 8% Yahoo borrows 12% Intl. Bank arranges swap Java swaps 8% $ loan for 10.3% yen loan w/bank Yahoo swaps 12% yen loan for 10.4% $ loan w/bank total available benefit = (11.1-8) - (12-11) = 2.1%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Currency Swaps example - cont benefit to Java $ loan = 0 Yen loan =.7net gain +.7% benefit to Yahoo $ loan = +.7 yen loan = 0net gain =.7% benefit to bank $ loan = +2.4 yen loan = -1.7net gain +.7%

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Derivative Innovations  The creative mind is the only barrier to new derivative products. Even Weather Derivatives have come into existence in recent years. Example: A TV network may want to hedge the risk of a World Series game being rained out and thus they forego advertising income. Who might the counterparty be to such a contract?

Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved McGraw-Hill/Irwin Web Resources Click to access web sites Internet connection required