0. Hedging with Financial
Chapter 24
Hedging with Financial
Derivatives

1. Chapter Preview
Starting in the 1970s, the world became a riskier place for financial institutions. Interest rate volatility increased, as did the stock and bond markets. Financial innovation helped with the development of derivatives. But if improperly used, derivatives can dramatically increase the risk institutions face.

2. Chapter Preview
In this chapter, we look at the most important derivatives that managers of financial institution use to manage risk. We examine how the markets for these derivatives work and how the products are used by financial managers to reduce risk. Topics include:
Hedging
Forward Markets
Financial Futures Markets

3. Chapter Preview (cont.)
Stock Index Futures
Options
Interest-Rate Swaps
Credit Derivatives

4. Hedging
Hedging involves engaging in a financial transaction that reduces or eliminates risk.
Definitions
long position: an asset which is purchased or owned
short position: an asset which must be delivered to a third party as a future date, or an asset which is borrowed and sold, but must be replaced in the future

5. Hedging
Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position.
We will examine how this is specifically accomplished in different financial markets.

6. Forward Markets
Forward contracts are agreements by two parties to engage in a financial transaction at a future point in time. Although the contract can be written however the parties want, the contact usually includes:
The exact assets to be delivered by one party, including the location of delivery
The price paid for the assets by the other party
The date when the assets and cash will be exchanged

7. Forward Markets An Example of an Interest-Rate Contract
First National Bank agrees to deliver $5 million in face value of 6% Treasury bonds maturing in 2032
Rock Solid Insurance Company agrees to pay $5 million for the bonds
FNB and Rock Solid agree to complete the transaction one year from today at the FNB headquarters in town

8. Forward Markets Long Position Short Position
Agree to buy securities at future date
Hedges by locking in future interest rate of funds coming in future, avoiding rate decreases
Short Position
Agree to sell securities at future date
Hedges by reducing price risk from increases in interest rates if holding bonds

9. Forward Markets Pros Cons Flexible
Lack of liquidity: hard to find a counter-party and thin or non-existent secondary market
Subject to default risk—requires information to screen good from bad risk

10. The Practicing Manager: Hedging Interest Rate Risk with Forwards
First National Bank owns $5 million of T-bonds that mature in Because these are long-term bonds, you are exposed to interest-rate risk. How do you hedge this risk?
Enter into a forward contract with Rock Solid Insurance company, where Rock Solid agrees to buy the bonds for $5m.

11. The Practicing Manager: Hedging Interest Rate Risk with Forwards
First National Bank is hedged against interest-rate increases
Rock Solid, on the other hand, has protected itself against rate declines.
Both parties can gain or lose, since we don’t know which way rates will actually go in one year. But both are better off. We’ll review the details a bit more…

12. Financial Futures Markets
Financial futures contracts are similar to forward contracts in that they are an agreement by two parties to engage in a financial transaction at a future point in time. However, they differ from forward contracts in several significant ways.

13. Financial Futures Markets
Financial Futures Contract
Specifies delivery of type of security at future date
Arbitrage: at expiration date, price of contract = price of the underlying asset delivered
i , long contract has loss, short contract has profit
Hedging similar to forwards: micro versus macro hedge
Traded on Exchanges
Global competition regulated by CFTC

14. Example: Hedging Interest Rate Risk Revisited
A manager has a long position in Treasury bonds. She wishes to hedge again interest rate increases, and uses T-bond futures to do this:
Her portfolio is worth $5,000,000
Futures contracts have an underlying value of $100,000, so she must short 50 contracts.

15. Example: Hedging Interest Rate Risk
As interest rates increase over the next 12 months, the value of the bond portfolio drops by almost $1,000,000.
However, the T-bond contract also dropped almost $1,000,000 in value, and the short position means the contact pays off that amount.
Losses in the spot T-bond market are offset by gains in the T-bond futures market.
You can see all of the details of this example in the book, on page 589.

16. Financial Futures Markets
The previous example is a micro hedge—hedging the value of a specific asset. Macro hedges involve hedging, for example, the entire value of a portfolio, or general prices for production inputs.

17. Financial Futures Markets
In the U.S., futures are traded on the CBOT and the CME in Chicago, the NY Futures Exchange, and others.
They are regulated by the Commodity Futures Trading Commission.

18. Following the News

19. Financial Futures Markets
The U.S. exchanges dominated the market for years. However, this isn’t true anymore.
The London Int’l Financial Futures Exchange trades Eurodollar futures
The Tokyo Stock Exchange trades Euroyen and gov’t bond futures
Several others as well, as seen next.

20. Table 24.1 Widely Traded Financial Futures Contracts

21. Financial Futures Markets
Success of Futures Over Forwards
Futures are more liquid: standardized contracts that can be traded
Delivery of range of securities reduces the chance that a trader can corner the market
Mark to market daily: avoids default risk
Don’t have to deliver: cash netting of positions

22. The Hunt Brothers and the Silver Crash
In the early 1980s, the Hunt brothers tried to corner the silver market by buying 300 million ounces of silver. The silver price rose from $6 to $50 an ounce.
The exchanges steps in, taking action to eliminate the corner. Silver dropped back to under $10 an ounce.
The Hunt brothers lost about $1 billion, a high price for an excursion in to the silver market.

23. Hedging FX Risk
Example: A manufacturer expects to be paid 10 million euros in two months for the sale of equipment in Europe. Currently, 1 euro = $1, and the manufacturer would like to lock-in that exchange rate.

24. Hedging FX Risk
The manufacturer can use the FX futures market to accomplish this:
The manufacturer sells 10 million euros of futures contracts. Assuming that 1 contract is for $125,000 in euros, the manufacturer takes as short position in 40 contracts.
The exchange will require the manufacturer to deposit cash into a margin account. For example, the exchange may require $2,000 per contract, or $80,000.

25. Hedging FX Risk
As the exchange rate fluctuates during the two months, the value of the margin account will fluctuate. If the value in the margin account falls too low, additional funds may be required. This is how the market is marked to market. If additional funds are not deposited when required, the position will be closed by the exchange.

26. Hedging FX Risk
Assume that actual exchange rate is 1 euro = $0.96 at the end of the two months. The manufacturer receives the 10 million euros and exchanges them in the spot market for $9,600,000.
The manufacturer also closes the margin account, which has $480,000 in it—$400,000 for the changes in exchange rates plus the original $80,000 required by the exchange (assumes no margin calls).
In the end, the manufacturer has the $10,000,000 desired from the sale.

27. Hedging FX Risk
Of course, the exchange rate could have gone the other way. For example, if the actual exchange rate is 1 euro = $1.04 at the end of the two months, the manufacturer will exchange the 10 million euros for $10,400,000. At the same time, losses in futures market amount to $400,000, netting the same $10,000,000. Just as happy? Probably not. Even though the hedge worked exactly as needed.

28. Stock Index Futures
Financial institution managers, particularly those that manage mutual funds, pension funds, and insurance companies, also need to assess their stock market risk, the risk that occurs due to fluctuations in equity market prices.
One instrument to hedge this risk is stock index futures.

29. Stock Index Futures
Stock index futures are a contract to buy or sell a particular stock index, starting at a given level. Contacts exist for most major indexes, including the S&P 500, Dow Jones Industrials, Russell 2000, etc.
The “best” stock futures contract to use is generally determined by the highest correlation between returns to a portfolio and returns to a particular index.

30. Following the News

31. Hedging with Stock Index Futures
Example: Rock Solid has a stock portfolio worth $100 million, which tracks closely with the S&P 500. The portfolio manager fears that a decline is coming and what to completely hedge the value of the portfolio over the next year. If the S&P is currently at 1,000, how is this accomplished?

32. Hedging with Stock Index Futures
Value of the S&P 500 Futures Contract = 250  index
currently 250  1,000 = $250,000
To hedge $100 million of stocks that move 1 for 1 (perfect correlation) with S&P currently selling at 1000, you would:
sell $100 million of index futures = 400 contracts

33. Hedging with Stock Index Futures
Suppose after the year, the S&P 500 is at 900 and the portfolio is worth $90 million.
futures position is up $10 million
If instead, the S&P 500 is at 1100 and the portfolio is worth $110 million.
futures position is down $10 million
Either way, net position is $100 million

34. Hedging with Stock Index Futures
Note that the portfolio is protected from downside risk, the risk that the value in the portfolio will fall. However, to accomplish this, the manager has also eliminated any upside potential.
Now we will examine a hedging strategy that protects again downside risk, but does not sacrifice the upside. Of course, this comes at a price!

35. Mini Case: Program Trading and the Market Crash of 1987
In the aftermath of the Black Monday crash on October 19, 1987, stock price index futures markets have been accused of being culprits in the market collapse.
Program trading between futures and stock prices creates a downward spiral. Other experts blame portfolio insurance, which can have the same affect.
Limits on program trading have been implements to reduce this problem in the future.

36. Options Options Contract
Right to buy (call option) or sell (put option) an instrument at the exercise (strike) price up until expiration date (American) or on expiration date (European).
Options are available on a number of financial instruments, including individual stocks, stock indexes, futures, etc.

37. Options on Futures
Long Call at agree to pay $115,000 for a $100,000 Treasury bonds at the end of February
Short Call at agree take $115,000 to deliver a $100,000 Treasury bonds at the end of February

38. Options on Futures Features of Treasury bond futures contract
Same expiration date as the futures contract
American option - exercisable until the expiration date
The premium is quoted in points, so each point corresponds to $1,000

39. Options Hedging with Options
Buy same number of put option contracts as would sell of futures
Disadvantage: pay premium
Advantage: protected if i increases, gain on contract
if i falls, additional advantage if macro hedge: avoids accounting problems, no losses on option
The next slide highlights these differences between futures and options

40. Options vs Futures
Figure 24.1 Profits and Losses on Options Versus Futures Contracts

41. Factors Affecting Premium
Higher strike price, lower premium on call options and higher premium on put options.
Greater term to expiration, higher premiums for both call and put options.
Greater price volatility of underlying instrument, higher premiums for both call and put options.

42. Hedging with Options
Example: Rock Solid has a stock portfolio worth $100 million, which tracks closely with the S&P 500. The portfolio manager fears that a decline is coming and what to completely hedge the value of the portfolio against any downside risk. If the S&P is currently at 1,000, how is this accomplished?

43. Hedging with Options
Value of the S&P 500 Option Contract = 100  index
currently 100  1,000 = $100,000
To hedge $100 million of stocks that move 1 for 1 (perfect correlation) with S&P currently selling at 1000, you would:
buy $100 million of S&P put options = 1,000 contracts

44. Hedging with Options
The premium would depend on the strike price. For example, a strike price of 950 might have a premium of $200 / contract, while a strike price of 900 might have a strike price of only $100.
Let’s assume Rock Solid chooses a strike price of 950. Then Rock Solid must pay $200,000 for the position. This is non-refundable and comes out of the portfolio value (now only $99.8 million).

45. Hedging with Options
Suppose after the year, the S&P 500 is at 900 and the portfolio is worth $89.8 million.
options position is up $5 million (since 950 strike price)
in net, portfolio is worth $94.8 million
If instead, the S&P 500 is at 1100 and the portfolio is worth $109.8 million.
options position expires worthless, and portfolio is worth $109.8 million

46. Hedging with Options
Note that the portfolio is protected from any downside risk (the risk that the value in the portfolio will fall ) in excess of $5 million. However, to accomplish this, the manager has to pay a premium upfront of $200,000.

47. 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.
Simplest type, called a plain vanilla swap, specifies (1) the rates being exchanged, (2) type of payments, and (3) notional amount.

48. Interest-Rate Swap Contract Example
Midwest Savings Bank wishes to hedge rate changes by entering into variable-rate contracts.
Friendly Finance Company wishes to hedge some of its variable-rate debt with some fixed-rate debt.
Notional principle of $1 million
Term of 10 years
Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Company.

49. Interest-Rate Swap Contract Example
Figure 24.2 Interest-Rate Swap Payments

50. Hedging with Interest-Rate Swaps
Reduce interest-rate risk for both parties
Midwest converts $1m of fixed rate assets to rate-sensitive assets, RSA, lowers GAP
Friendly Finance RSA, lowers GAP

51. Hedging with Interest-Rate Swaps
Advantages of swaps
Reduce risk, no change in balance-sheet
Longer term than futures or options
Disadvantages of swaps
Lack of liquidity
Subject to default risk
Financial intermediaries help reduce disadvantages of swaps (but at a cost!)

52. Credit Derivatives
Credit derivatives are a relatively new derivative offering payoffs based on changes in credit conditions along a variety of dimensions. Almost nonexistent twenty years ago, the notional amount of credit derivatives today is in the trillions.

53. Credit Derivatives
Credit derivatives can be generally categorized as credit options, credit swaps, and credit-linked notes. We will look at each of these in turn.

54. Credit Derivatives
Credit options are like other options, but payoffs are tied to changes in credit conditions.
Credit options on debt are tied to changes in credit ratings.
Credit options can also be tied to credit spreads. For example, the strike price can be a predetermined spread between AAA-rated and BBB-rated corporate debt.

55. Credit Derivatives
Credit options are like other options, but payoffs are tied to changes in credit conditions.
Credit options on debt are tied to changes in credit ratings.
Credit options can also be tied to credit spreads. For example, the strike price can be a predetermined spread between BBB-rated corporate debt and T-bonds.

56. Credit Derivatives
For example, suppose you wanted to issue $100,000,000 in debt in six months, and your debt is expected to be rated single-A. Currently, A-rated debt is trading at 100 basis points above the Treasury. You could enter into a credit option on the spread, with a strike price of 100 basis points.

57. Credit Derivatives
If the spread widens, you will, of course, have to issue the debt at a higher-than-expected interest rate. But the additional cost will be offset by the payoff from the option. Like any option, you will have to pay a premium upfront for this protection.

58. Credit Derivatives
Credit swaps involve, for example, swapping actual payments on similar-sized loan portfolios. This allows financial institutions to diversify portfolios while still allowing the lenders to specialize in local markets or particular industries.

59. Credit Derivatives
Another form of a credit swap, called a credit default swap, involves option-like payoffs when a basket of loans defaults. For example, the swap may payoff only after the 5th bond in a bond portfolio defaults (or has some other bad credit event).

60. Credit Derivatives
Credit-linked notes combine a bond and a credit option. Like any bond, it makes regular interest payments and a final payment including the face value. But the issuer has an option tied to a key variable.

61. Credit Derivatives
For example, GM might issue a bond with a 5% coupon rate. However, the covenants would stipulate that if an index of SUV sales falls by more than 10%, the coupon rate drops to 3%. This would be especially useful if GM was using the bond proceeds to build a new SUV plant.

62. Are derivatives a time bomb?
In the 2002 annual report for Berkshire Hathaway, Warren Buffett referred to derivatives (bought for speculation) as “…weapons of mass destruction.” (although also noting that Berkshire uses derivatives). Is he right?

63. Are derivatives a time bomb?
There are three major concerns with the use of financial derivatives:
Derivatives allow financial institutions to increase their leverage (effectively changing their capital), possibly to take on more risk
Derivatives are too complicated
The derivative positions of some banks exceed their capital—the probability of failure has greatly increased

64. Are derivatives a time bomb?
As usual, the blanket comments are usually not accurate. For example, although the notional amount of derivatives exceeds capital, often these are offsetting positions on behalf of clients—the bank has no exposure. In other words, you have to look at each situation individually. Further, actual derivative losses by banks is small, despite a few news-worthy exceptions.

65. Are derivatives a time bomb?
Of course, the financial crisis only further illustrates the problem of speculative derivatives. AIG, for example, sought fee revenue from taking the short side of credit default swaps. Unfortunately, when housing prices collapsed, they have to payout on those positions, resulting in billions in losses (to you me in the end!).

66. Are derivatives a time bomb?
In the end, derivatives do have their dangers. But so does hiring crooks to run a bank (Lincoln S&L ring a bell). But derivatives have changed the sophistication needed by both managers and regulators to understand the whole picture.

67. Chapter Summary
Hedging: the basic idea of entering into an offsetting contract to reduce or eliminate some type of risk was presented.
Forward Markets: the basic idea of contracts in this highly specialized market, as well as a simple example of eliminating risk was presented.

68. Chapter Summary (cont.)
Financial Futures Markets: these exchange traded markets were presented, as well as their advantages over forward contacts.
Stock Index Futures: the specific application of stock index futures was presented, exploring their ability to reduce or eliminate risk for equity portfolios.

69. Chapter Summary (cont.)
Options: these contracts, which give the buyer the right but not the obligation to act, were presented, as well as an example showing their costs.
Interest-Rate Swaps: the idea of trading fixed-rate interest payments for floating-rate payments was presented, as well as the pros and cons of such contracts.

70. Chapter Summary (cont.)
Credit Derivatives: we examine this relatively new market for hedging the credit risk of portfolios and the dangers involved.