Chapter 25 Hedging with Financial Derivatives Chapter Preview Starting 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 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 3 Chapter Preview cont Stock Index Futures Options Interest Rate Swaps Credit Derivatives Copyright 2009 Pearson Prentice Hall All rights reserved 25 4 Hedging Hedging involves engaging in a financial transaction that reduces or eliminates risk Definitions or owned long position an asset which is purchased 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 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 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 exchanged Copyright 2009 Pearson Prentice Hall All rights reserved 25 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 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 town Copyright 2009 Pearson Prentice Hall All rights reserved 25 8 Forward 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 bonds Copyright 2009 Pearson Prentice Hall All rights reserved 25 9 Forward Markets Pros 1 Flexible Cons 1 Lack of liquidity hard to find a counter party and thin or non existent secondary market 2 Subject to default risk requires information to screen good from bad risk Copyright 2009 Pearson Prentice Hall All rights reserved 25 10 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 11 Financial Futures Markets Success of Futures Over Forwards 1 Futures are more liquid standardized contracts that can be traded 2 Delivery of range of securities reduces the chance that a trader can corner the market 3 Mark to market daily avoids default risk 4 Don t have to deliver cash netting of positions Copyright 2009 Pearson Prentice Hall All rights reserved 25 12 Example 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 13 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 14 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 15 Following the News 25 16 Widely Traded Financial Futures Contracts 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 18 Hedging FX Risk The manufacturer can use the FX futures market to accomplish this 1 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 80 contracts 2 The exchange will require the manufacturer to deposit cash into a margin account For example the exchange may require 1 000 per contract or 80 000 Copyright 2009 Pearson Prentice Hall All rights reserved 25 19 Hedging FX Risk 3 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 margin call 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 Copyright 2009 Pearson Prentice Hall All rights reserved 25 20 Hedging FX Risk 4 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 5 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