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Chapter 22Managing Financial Risk

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Derivative Securities• Derive their value from primary securitiesDerive their value from primary securities• Primary financial instrument evidences a direct Primary financial instrument evidences a direct

claim against some other partyclaim against some other party• Traded in the spot market with prices set by the Traded in the spot market with prices set by the

forces of supply and demandforces of supply and demand• Put and call options on stocksPut and call options on stocks• Cascade of new derivativesCascade of new derivatives• Require sophisticated computer programming to Require sophisticated computer programming to

unravel the complication of many derivativesunravel the complication of many derivatives• Insulate a corporation from different types of riskInsulate a corporation from different types of risk

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Hedging Risk

• Taking a derivative position opposite to your Taking a derivative position opposite to your exposureexposure

• Value of the instruments used to hedge do Value of the instruments used to hedge do not move in concertnot move in concert

• Slight to moderate deviations create basis Slight to moderate deviations create basis riskrisk

• Use futures contracts, forward contracts, Use futures contracts, forward contracts, options, or swapsoptions, or swaps

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Hedging Fundamentals

• Hedge ratio is the ratio of one position relative to the Hedge ratio is the ratio of one position relative to the other where risk is neutralizedother where risk is neutralized

• Must adjust the hedge ratio over time (known as Must adjust the hedge ratio over time (known as dynamic hedging) if risk is to be minimizeddynamic hedging) if risk is to be minimized

• The lower the transaction cost, the more that The lower the transaction cost, the more that adjustments can occur and the more that risk is adjustments can occur and the more that risk is minimizedminimized

• Requires continual vigilance if risk is to be Requires continual vigilance if risk is to be controlledcontrolled

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Arguments for Corporate Hedging• With imperfections hedging may be a thing of valueWith imperfections hedging may be a thing of value• Reduce total cash-flow and expected cost of Reduce total cash-flow and expected cost of

bankruptcy bankruptcy • Reduce agency costsReduce agency costs• Reduce the problem of underinvestmentReduce the problem of underinvestment• May reduce some taxesMay reduce some taxes• Stabilize accounting earnings and reduce the Stabilize accounting earnings and reduce the

probability of falling below some regulatory probability of falling below some regulatory requirementrequirement

• Insulate operating managers from the vagaries of Insulate operating managers from the vagaries of interest-rate changes and currency movementsinterest-rate changes and currency movements

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Futures Market• Futures contract is a standardized agreement that Futures contract is a standardized agreement that

calls for delivery of a commodity at some specific calls for delivery of a commodity at some specific future datefuture date

• With financial futures the commodity is a securityWith financial futures the commodity is a security• Only a small percentage of contracts come to Only a small percentage of contracts come to

actual deliveryactual delivery– Buyers and sellers take offsetting positionsBuyers and sellers take offsetting positions

• Open interest is the number of futures contracts Open interest is the number of futures contracts outstanding that have not been closedoutstanding that have not been closed

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Several Interest-Rate Futures Markets

• EurodollarsEurodollars• Treasury notes Treasury notes Most important, volume wiseMost important, volume wise

• Treasury bondsTreasury bonds

• Federal fundsFederal funds

• 1-month LIBOR 1-month LIBOR

• Treasury billsTreasury bills

• Municipal bondsMunicipal bonds

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Features of Futures Markets• Money market instrumentsMoney market instruments• Margin requirementsMargin requirements

– Amount of money that must be pledged to cover fluctuations Amount of money that must be pledged to cover fluctuations in the market price of the contract, and is subject to daily resetin the market price of the contract, and is subject to daily reset

– Initial and maintenance margin requirementsInitial and maintenance margin requirements– Marked-to-market means daily valuation of a contract with Marked-to-market means daily valuation of a contract with

the loser owing money to the winnerthe loser owing money to the winner

• Longer-term instrumentsLonger-term instruments – Settlement price multiplied by a conversion factorSettlement price multiplied by a conversion factor– Established for each coupon rate and time to maturityEstablished for each coupon rate and time to maturity

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Hedging and Speculation• Hedging represents taking a futures contract position Hedging represents taking a futures contract position

opposite to a position taken in the spot market to reduce opposite to a position taken in the spot market to reduce risk exposurerisk exposure

• Speculator takes position in futures markets in the pursuit Speculator takes position in futures markets in the pursuit of profits and assumes price riskof profits and assumes price risk

• Long hedges involves buying a futures contractLong hedges involves buying a futures contract

– Futures market provides a “two-sided” hedgeFutures market provides a “two-sided” hedge

• Short hedges involves writing a contract Short hedges involves writing a contract

– Cross hedgeCross hedge

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Basis Risk• Is the random fluctuation in net position that Is the random fluctuation in net position that

remains after hedgingremains after hedging

Future price (adjustedFuture price (adjusted• Basis = Spot market - by appropriateBasis = Spot market - by appropriate price conversion factor)price conversion factor)• Spot price less the futures price should equal the Spot price less the futures price should equal the

cost of carry cost of carry – Positive carryPositive carry– Negative carry Negative carry

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Forward Contract

• Serves the same economic function as a Serves the same economic function as a futures contract but is different in the detailfutures contract but is different in the detail

• With interest-rate forward contracts, the With interest-rate forward contracts, the forward rate is that rate at which two parties forward rate is that rate at which two parties agree to lend and borrow money for a agree to lend and borrow money for a specified period of time in the futurespecified period of time in the future

• Forward and futures contracts are two sided Forward and futures contracts are two sided hedgeshedges

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DifferencesForwardForward

• Nonstandard contractNonstandard contract• No clearinghouseNo clearinghouse• Over-the -counterOver-the -counter• Less liquidLess liquid• Settlement at maturitySettlement at maturity• Customized amountCustomized amount• More credit riskMore credit risk

FuturesFutures• StandardStandard• ClearinghouseClearinghouse• Exchange marketExchange market• LiquidLiquid• Daily settlementDaily settlement• Specific sizeSpecific size• SaferSafer

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Option Contract• One sided hedgesOne sided hedges

• Debt optionsDebt options

– EurodollarsEurodollars

– Treasury bondTreasury bond

– Treasury notesTreasury notes

– British and German long-term debtBritish and German long-term debt

• Use of hedge optionsUse of hedge options

– Hedge risk or place bets on the direction and/or Hedge risk or place bets on the direction and/or volatility on interest ratesvolatility on interest rates

Volume is heaviest

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Caps, Floors, and Collars

• Cap is a put option on a fixed-income Cap is a put option on a fixed-income security’s valuesecurity’s value

• Floor is a call optionFloor is a call option

• Collar is a combination of a cap and a floor, Collar is a combination of a cap and a floor, with variation only in the mid-rangewith variation only in the mid-range

• Developed as customized derivative Developed as customized derivative productsproducts

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Valuation of Debt Options• Use option pricing models in the spirit of Black-Use option pricing models in the spirit of Black-

ScholesScholes

• Key is the volatility of returns for the associated asset Key is the volatility of returns for the associated asset having to do with the variability of interest rateshaving to do with the variability of interest rates

• Bond’s return variance declines as maturity Bond’s return variance declines as maturity approachesapproaches

• When properly modified, the Black-Scholes model When properly modified, the Black-Scholes model gives reasonable explanations of debt option pricinggives reasonable explanations of debt option pricing

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Options on Yield Spreads• Spread is a long-term Treasury interest rate minus a Spread is a long-term Treasury interest rate minus a

shorter-term rateshorter-term rate• All settlements are on a cash basisAll settlements are on a cash basis• Exercise price is expressed in terms of basis pointsExercise price is expressed in terms of basis points• Option is in the money when the actual yield spread Option is in the money when the actual yield spread

turns out to be greater than the exercise priceturns out to be greater than the exercise price• Call option holder bets the term structure of interest Call option holder bets the term structure of interest

rates will widen, whereas with a put option it will rates will widen, whereas with a put option it will flattenflatten

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Interest-Rate Swaps• Exchanges a floating-rate obligation for a fixed-rate Exchanges a floating-rate obligation for a fixed-rate

one, or vice versaone, or vice versa• With a currency swap interest obligations are With a currency swap interest obligations are

exchanged in different currenciesexchanged in different currencies• With an interest-rate swap, interest-payment With an interest-rate swap, interest-payment

obligations are exchanged between two parties obligations are exchanged between two parties denominated in the same currencydenominated in the same currency

• Floating-/fixed-rate exchangeFloating-/fixed-rate exchange– A fixed-rate interest payment is exchanged for a floating rateA fixed-rate interest payment is exchanged for a floating rate

• Basis swapBasis swap– Two floating-rate obligations are exchangedTwo floating-rate obligations are exchanged

• Swaps can be customizedSwaps can be customized

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Swap Valuation Issues

• Comparative advantage is a result of Comparative advantage is a result of imperfections and disparate informationimperfections and disparate information

• By exploiting market incompleteness in By exploiting market incompleteness in interest-rate management, the swap may interest-rate management, the swap may benefit all partiesbenefit all parties

• Swaps may allow a party to get around tax Swaps may allow a party to get around tax laws and regulationslaws and regulations

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Credit Risk• Default risk with respect to differential in interest Default risk with respect to differential in interest

paymentspayments• Intermediaries increasingly interposed themselves Intermediaries increasingly interposed themselves

between the parties in such a way as to assume the between the parties in such a way as to assume the default riskdefault risk

• Replacement risk is that of having to replace a Replacement risk is that of having to replace a counterparty in case of defaultcounterparty in case of default

• Swap positions can be sold giving them a degree of Swap positions can be sold giving them a degree of liquidity not found in many loansliquidity not found in many loans

• Standardized contract specifies how swaps are to be Standardized contract specifies how swaps are to be liquidated in event of defaultliquidated in event of default

• Margin is not sufficient to compensate for the credit risk Margin is not sufficient to compensate for the credit risk if default occursif default occurs

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Secondary Market Values

• In a swap sale, a position is sold to another In a swap sale, a position is sold to another party and there is no further obligationparty and there is no further obligation

• In a swap reversal, offsetting swaps are sold In a swap reversal, offsetting swaps are sold removing interest rate risk with credit risk removing interest rate risk with credit risk remaining remaining

• An interest-rate swap is like a series of An interest-rate swap is like a series of futures or forward contractsfutures or forward contracts

• Mark-to-market is required every dayMark-to-market is required every day

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Swaptions

• Options that exist for swap transactionsOptions that exist for swap transactions• Call swaption, if exercised, involves paying a Call swaption, if exercised, involves paying a

floating rate and receiving a fixed rate in the floating rate and receiving a fixed rate in the swapswap

• Put swaption, if exercised, involves paying a Put swaption, if exercised, involves paying a fixed rate and receiving a floating ratefixed rate and receiving a floating rate

• Cancel a swap contractCancel a swap contract• Futures and forward contracts on swapsFutures and forward contracts on swaps

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Credit Derivatives

• Unbundle default risk from the other features of a Unbundle default risk from the other features of a loanloan– Can be transferred to others for a priceCan be transferred to others for a price

• Protection buyer transfers riskProtection buyer transfers risk• Protection seller assumes the credit risk and Protection seller assumes the credit risk and

receives a premium for providing the insurancereceives a premium for providing the insurance• Credit-swap spread is the periodic premium paidCredit-swap spread is the periodic premium paid

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Total Return Swap

Protection

Seller

Protection

BuyerDebt instrument’s total return

Reference rate +/- spread

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Credit Swap

Protection

Seller

Protection

Buyer

Premium

No credit event: $0

Credit event: Face value-market value

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Defining Default, and Liquidity in the Market

• Economic default may occur well before Economic default may occur well before legal defaultlegal default

• Liquidity in the credit derivative market is Liquidity in the credit derivative market is limitedlimited

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Other Credit Derivatives• Spread adjusted notes involve resets based on Spread adjusted notes involve resets based on

the spread of a particular grade of security the spread of a particular grade of security over Treasuriesover Treasuries

• Credit option involves puts and calls based on Credit option involves puts and calls based on a basket of corporate fixed-income securitiesa basket of corporate fixed-income securities

• Credit-sensitive notes involve coupon rate Credit-sensitive notes involve coupon rate changes when the credit rating changes for changes when the credit rating changes for the company the company

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Commodity Contracts• Agricultural productsAgricultural products• Nonagricultural productsNonagricultural products• FeaturesFeatures

– Often involve storage costs and perishabilityOften involve storage costs and perishability– Futures marketsFutures markets– Options on commodity futuresOptions on commodity futures– Traded on a number of exchangesTraded on a number of exchanges– Clearinghouse functionClearinghouse function

• Used by hedgers to shift price riskUsed by hedgers to shift price risk• Used by speculators to bet on the future course of Used by speculators to bet on the future course of

pricesprices• Principles are the same as for interest-rate contractsPrinciples are the same as for interest-rate contracts