Chapter 25Chapter PreviewSlide 3Chapter Preview (cont.)HedgingSlide 6Forward MarketsSlide 8Slide 9Slide 10Financial Futures MarketsSlide 12Example: Hedging Interest Rate RiskSlide 14Slide 15Following the NewsWidely Traded Financial Futures ContractsHedging FX RiskSlide 19Slide 20Slide 21Stock Index FuturesSlide 23Hedging with Stock Index FuturesSlide 25Slide 26Slide 27OptionsSlide 29Slide 30Profit Profiles for CallsProfit Profiles for PutsProtective Put ProfitCovered Call ProfitFactors Affecting PremiumHedging with OptionsSlide 37Slide 38Slide 39Slide 40Interest-Rate SwapsMismatch in durations of Mutual savings bank and Finance companyInterest-Rate Swap Contract ExampleSlide 44Hedging with Interest-Rate SwapsSlide 46Credit DerivativesSlide 48Slide 49Slide 50Slide 51Slide 52Slide 53Slide 54CDS and Systemic Risks: Domino ModelSlide 56Slide 57Are derivatives a time bomb?Slide 59Slide 60Slide 61Chapter 25Hedging with Financial DerivativesCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-2Chapter PreviewStarting in the 1970s, the world became a riskier place for financial institutions. Interest rate and exchange 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.Copyright © 2009 Pearson Prentice Hall. All rights reserved.25-3Chapter 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 MarketsCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-4Chapter Preview (cont.)–Stock Index Futures–Options–Interest-Rate Swaps–Credit DerivativesCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-5Hedging•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 futureCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-6Hedging•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.Copyright © 2009 Pearson Prentice Hall. All rights reserved.25-7Forward 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 contract 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 exchangedCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-8Forward 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 2023–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 townCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-9Forward Markets•Long 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 bondsCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-10Forward Markets•Pros 1. Flexible•Cons1. Lack of liquidity: hard to find a counter-party and thin or non-existent secondary market2. Subject to default risk—requires information to screen good from bad riskCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-11Financial 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.Copyright © 2009 Pearson Prentice Hall. All rights reserved.25-12Financial Futures Markets•Success of Futures Over Forwards1. Futures are more liquid: standardized contracts that can be traded2. Delivery of range of securities reduces the chance that a trader can corner the market3. Mark to market daily: avoids default risk4. Don't have to deliver: cash netting of positionsCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-13Example: Hedging Interest Rate Risk•A manager has a long position in Treasury bonds. She wishes to hedge against 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.Copyright © 2009 Pearson Prentice Hall. All rights reserved.25-14Example: 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.Copyright © 2009 Pearson Prentice Hall. All rights reserved.25-15Financial 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.25-16Following the NewsWidely Traded Financial Futures ContractsCopyright © 2009 Pearson Prentice Hall. All rights reserved.25-18Hedging 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.Copyright © 2009 Pearson Prentice Hall. All rights reserved.25-19Hedging FX Risk•The manufacturer can use the FX futures market to accomplish