1. Chapter 24 Appendix 1 More on Hedging with Financial Derivatives

2. 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.

3. 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 2025. Will use exchange-traded futures contract to hedge risk. Short position. But how many contracts? No perfect match in futures market.

4. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-3 Micro Hedge Example

5. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-4 Micro Hedge Example

6. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-5 Micro Hedge Example

7. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-6 Micro Hedge Example (a)

8. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-7 Micro Hedge Example (b)

9. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-8 Micro Hedge Example (c)

10. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-9 Micro Hedge Example (d)

11. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-10 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.

12. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-11 Macro Hedge Example

13. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-12 Macro Hedge Example (a)

14. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-13 Macro Hedge Example (b)

15. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-14 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.

16. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-15 Futures Options Hedge Example

17. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-16 Futures Options Hedge Example

18. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-17 Futures Options Hedge Example

19. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-18 Futures Options Hedge Example (a)

20. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-19 Futures Options Hedge Example (b)

21. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-20 Futures Options Hedge Example (c)

22. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-21 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?

23. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-22 Interest-Rate Swaps Hedge Example

24. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-23 Interest-Rate Swaps Hedge Example (a)

25. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-24 Macro Hedge Example (b)

26. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-25 Stock Index Futures Stock index futures can be used to hedge two situations: ─ Reduce systematic risk ─ Lock in stock prices

27. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-26 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%.

28. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-27 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

29. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-28 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

30. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-29 Hedging with Stock Index Futures 

31. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-30 Hedging with Stock Index Futures: Example (a)

32. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-31 Hedging with Stock Index Futures: Example (b)

33. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-32 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.

34. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-33 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!

35. Copyright ©2015 Pearson Education, Inc. All rights reserved.24-34 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!