1. J. K. Dietrich - FBE 432 – Spring, 2002 Module III: Practical Issues and Value Creation Using Derivatives Week 9 – October 21 and 23, 2002

2. J. K. Dietrich - FBE 432 – Spring, 2002 Session Outline u Complete discussions from Weeks 7 and 8 concerning interest-rate risk management u Outline some points to consider in Union Carbide case u Discuss some recent examples of problems using derivatives

3. J. K. Dietrich - FBE 432 – Spring, 2002 Factor Model Risk Measures u The general factor model expresses the portfolio (or firm) returns (or cash flows) as a linear function of a number of factors u Example: the familiar CAPM market model is a single-factor model –The stock’s return is expressed as a linear function of the market factor –But many industrial firms and banks are also exposed to significant interest rate risk

4. J. K. Dietrich - FBE 432 – Spring, 2002 Stylized Example u Suppose Citibank’s cash flows are negatively related to interest rate movements but increase with the Yen/$ rate. Define C = cash flow, millions of U.S. dollars a month F curr = the percentage change in the Yen/$ exchange rate, monthly F int = the change in LIBOR, monthly

5. J. K. Dietrich - FBE 432 – Spring, 2002 Regression Measuring Risk u The firm estimates a two-factor model (using regression analysis) of the form:  The term  represents idiosyncratic or unsystematic risks and the  coefficients are the factor loadings u Sign (positive or negative) indicates whether firm has long or short exposure to risk (but be careful with interest rates)

6. J. K. Dietrich - FBE 432 – Spring, 2002 Hedging Balance Sheet Risk u Hedging on balance sheet –Assets and liabilities chosen to offset risks –Changing mismatches of assets and/or liabilities through swaps –Floating rate securities with short re-pricing intervals have little interest-rate risk (low duration) u Hedging off balance sheet –Futures, forward contracts, and options

7. J. K. Dietrich - FBE 432 – Spring, 2002 Balance Sheet Hedges u Example: United Airlines receives income in Canadian dollars from its operations in Canada u In 1997-98, the Canadian dollar depreciated against the US Dollar. u How can United hedge its currency risk from Canadian operations?

8. J. K. Dietrich - FBE 432 – Spring, 2002 Balance Sheet Hedge u Consider taking a long-term liability in Canadian dollars to offset the (risky) income in Canadian dollars from UAL’s operations in Canada –A bank loan or bond issue (in Canada or Eurobonds denominated in Canadian dollars), generates cash which can be converted to US dollars –Interest obligations are met from Canadian income

9. J. K. Dietrich - FBE 432 – Spring, 2002 Balance Sheet Hedge Income in Canada Canadian Dollar Liability Initial Cash Inflow is converted to US Dollars

10. J. K. Dietrich - FBE 432 – Spring, 2002 Swaps u Exchange of future cash flows based on movement of some asset or price –Interest rates –Exchange rates –Commodity prices or other contingencies u Swaps are all over-the-counter contracts u Two contracting entities are called counter-parties u Financial institution can take both sides

11. J. K. Dietrich - FBE 432 – Spring, 2002 Interest Rate Swap: Plain vanilla, LIBOR@5.5% Company A (receive floating) Company B (receive fixed) Notional Amount $100 mm $2.75mm 1/2 5% fixed 1/2 6-month LIBOR $2.5mm

12. J. K. Dietrich - FBE 432 – Spring, 2002 Example: Interest Rate Swap u Two companies want to borrow $10 million with a 5 year duration u Company A, a financial institution, can borrow at fixed rate of 10%; B can borrow at a 11.2% fixed rate u Company A can borrow at a floating rate of 6 month LIBOR + 0.3%; B can borrow at a floating rate of 6 month LIBOR + 1%

13. J. K. Dietrich - FBE 432 – Spring, 2002 Comparative Advantage A:10%LIBOR + 0.3% B:11.2%LIBOR + 1% FixedFloating 1.2%0.7% Difference

14. J. K. Dietrich - FBE 432 – Spring, 2002 Preferences u Company A prefers floating interest debt while B wants to lock in a fixed rate u However, A has a comparative advantage in the fixed rate market while B has a comparative advantage in the floating rate market

15. J. K. Dietrich - FBE 432 – Spring, 2002 Swap Mechanics u Suppose A borrows at 10% fixed and B borrows at LIBOR + 1%, and then the two companies swap flows u Company A pays B interest at 6-month LIBOR on $10 million u Company B pays A interest at 9.95% per annum on $10 million

16. J. K. Dietrich - FBE 432 – Spring, 2002 Interest Rate Swap AB LIBOR 9.95% 10% LIBOR +1%

17. J. K. Dietrich - FBE 432 – Spring, 2002 Both Parties are Better Off u Cost to A: –10% to outside bank - 9.95% from B + LIBOR = LIBOR + 0.05% –Cost saving is 25 basis points per year u Cost to B: –LIBOR + 1% to outside bank - LIBOR from A + 9.95% to A = 10.95% –Cost saving is 25 basis points per year

18. J. K. Dietrich - FBE 432 – Spring, 2002 Swaps: Some fine points u The source of the gain is the fact that the two firms have different comparative advantages; even though A has an absolute advantage, there are still gains from trade u The total gain is 0.25% + 0.25% = 0.5% = 1.2% - 0.7%, the difference in the relative borrowing costs

19. J. K. Dietrich - FBE 432 – Spring, 2002 Swaps in Practice u Note that a swap does not involve the exchange of principals –All that is swapped is the cash flows u To guard against default, the deal will typically be structured with an intermediary (usually a large bank) between the two parties

20. J. K. Dietrich - FBE 432 – Spring, 2002 Swap: Bank Intermediary AB LIBOR 9.95% 10% LIBOR +1% Bank Even with fees, both parties are still better off LIBOR- 0.05% 9.90% Bank fees are 0.1%

21. J. K. Dietrich - FBE 432 – Spring, 2002 Swaps in Practice u The intermediary will charge fees for acting as a clearing house and guaranteeing the payments u As long as these fees are below 0.5%, all parties can be made better off u If the deal is put together by the intermediary, it is not necessary for either firm to know the trade counter-party

22. J. K. Dietrich - FBE 432 – Spring, 2002 Swaps in Practice u Many interest rate swaps also involve currency swaps or commodity swaps u Recently, the swap market has grown so rapidly that dealers will act as counterparties

23. J. K. Dietrich - FBE 432 – Spring, 2002 Dealer Quotations for Swaps u Example: –IBM can issue fixed rate bonds at 7.0% per annum. IBM wants a floating rate obligation believing rates will fall. –An OTC dealer gives IBM a fixed rate quote of 60 basis points over treasuries to be exchanged for 6-month LIBOR on a 5 year swap –If 5-year treasuries are at 5.53%, this quote means that you can get 6-month LIBOR by paying 6.13% (= 5.53% +0.60) fixed rate. –In IBM’s case, it would thus get 6.13% from the counterparty (or dealer) and would have to pay 6-month LIBOR, plus the 7.0% on its original debt –All-in costs are approximately LIBOR+ 0.87%

24. J. K. Dietrich - FBE 432 – Spring, 2002 The Value of Swaps u Swaps are beneficial because they allow hedging with one contract since they typically involve cash flows over several years u There are no losers; financial engineering results in value creation u The source of this value is in overcoming segmented markets

25. J. K. Dietrich - FBE 432 – Spring, 2002 Interest-Rate Derivatives u Interest rates and asset values move in opposite directions u Long cash means short assets u Short cash means long (someone else’s) asset u Basis risk comes from spreads between exposure and hedge instrument, e.g. default risk premiums u Problem with production risk, e.g. interest rates up, needs for funds may be down with slowdown

26. J. K. Dietrich - FBE 432 – Spring, 2002 Caps, floors, and collars u If a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note u If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call u A collar is a cap and a floor

27. J. K. Dietrich - FBE 432 – Spring, 2002 Collars: Cap 6%, floor 4% Profit 0 Loss 940095009600

28. J. K. Dietrich - FBE 432 – Spring, 2002 Other option developments u Credit risk options u Casualty risk options u Requirements for developing an option –Interest –Calculable payoffs –Enforceable

29. J. K. Dietrich - FBE 432 – Spring, 2002 Replication Futures with Options P0P0 P0P0 Long Profit Loss 0 0 Profit Loss Buy Call Write Put

30. J. K. Dietrich - FBE 432 – Spring, 2002 Short and Long Treasury Rates Source: FRB St. Louis

31. J. K. Dietrich - FBE 432 – Spring, 2002 Treasury Rates since 1970

32. J. K. Dietrich - FBE 432 – Spring, 2002 Orange County, November, 1994 u Citron bet on the yield curve and short-term rates staying low –Advised by investment bankers –“Leveraged” bet by »Structured notes (inverse floaters) »Borrowing using reverse repos u Duration mis-measured –Short-term portfolio (e.g. T-Bills) roughly.25 –Orange County duration raised to around 7

33. J. K. Dietrich - FBE 432 – Spring, 2002 Metall Gesellschaft u American unit of German company hedged short oil position –Strategy theoretically sound, as illustrated in Merton Miller article –Problem in required size of position –Analog in GM case for five-year note would be 5 times $400 million or $2 billion in futures u Hedging assumes markets are liquid and prices are valid

34. J. K. Dietrich - FBE 432 – Spring, 2002 Long-Term Capital Management u LTCM’s strategy depended on using arbitrage (risk-free buying and selling of assets) to make profits from temporary pricing anomalies u Used derivatives (e.g. futures and forwards, options, etc.) to arbitrage pricing of –European bond yields, expected to converge –30-year versus 29+year U.S. Treasuries –Russian and junk bonds

35. J. K. Dietrich - FBE 432 – Spring, 2002 Arbitrage and Derivative Prices u Markets are assumed to be liquid and mostly efficient u Prices are assumed to be good for large transactions u Arbitrage position can be closed or off-set at equilibrium values u Market imperfections are reality –Russian and global liquidity collapse in 1998 –Stock market crash of 1987 and derivatives

36. J. K. Dietrich - FBE 432 – Spring, 2002 Derivatives: Summary u Derivatives have been an important and beneficial expansion of financial markets –Allow better risk management –Enables more explicit pricing of risks/returns u Assumptions used to price derivatives are not always satisfied in the market-place u Government often steps in to change the rules and incentives for players in the “game”

37. J. K. Dietrich - FBE 432 – Spring, 2002 Next -- October 28 & 30, 2002 u Midterm discussed u Review RWJ, Chapters 6 and 7, for next class u Read and think about issues in Financing PPL Corporation’s Growth Strategy case