Chapter Twenty Three Hedging with Financial Derivatives

Chapter Twenty Three Hedging with Financial Derivatives

Basic Principle of Hedging • Hedging involves engaging in a financial transaction that offsets a long position with an additional short position, or offsets a short position with an additional long position 3

Forward Markets • Long Position – Agree to buy securities at future date – Hedges by locking in future interest rate if funds coming in future • Short Position – Agree to sell securities at future date – Hedges by reducing price risk from change in interest rates if holding bonds • Pros 1. Flexible • Cons 1. Lack of liquidity: hard to find counter-party 2. Subject to default risk— requires information to screen good from bad risk 4

Financial Futures Markets • Financial Futures Contract 1. Specifies delivery of type of security at future date 2. Arbitrage: at expiration date, price of contract = price of the underlying asset delivered 3. i , long contract has loss, short contract has profit 4. Hedging similar to forwards: micro versus macro hedge • Traded on Exchanges – Global competition regulated by CFTC Commodity Futures Options Trading, Inc. home page http: //www. usafutures. com 5

Financial Futures Markets (cont. ) • Success of Futures Over Forwards 1. Futures more liquid: standardized, can be traded again, delivery of range of securities 2. Delivery of range of securities prevents corner 3. Mark to market: avoids default risk 4. Don't have to deliver: netting 6

Widely Traded Financial Futures Contracts

Hedging FX Risk • Example: Customer due 10 million euros in two months, current 1 euro = $1 1. Forward agreeing to sell 10 million euros for $10 million, two months in future 2. Sell 10 million euros of futures = 40 contracts (40 $125, 000) 8

Hedging with Stock Index Futures • S&P Contract = 250 index • To hedge $100 million of stocks that move 1 for 1 with S&P currently selling at 1000 • Sell $100 million of index futures = 400 contracts = $100 million/$250, 000 9

Options • Options Contract – Right to buy (call option) or sell (put option) instrument at exercise (strike) price up until expiration date (American) or on expiration date (European) • Hedging with Options – Buy same number of put option contracts as would sell of futures – Disadvantage: pay premium – Advantage: protected if i, gain • if i – Additional advantage if macro hedge: avoids accounting problems, no losses on option when i 10

Profits and Losses: Options versus Futures • $100, 000 T-bond contract – Exercise price of 115, $115, 000 – Premium = $2, 000 Interactive calculator for valuing options http: //www. intrepid. com/~robertl/option-pricer 4. html 11

Figure 23 -1: Profits and Losses on Options versus Futures Contracts

Factors Affecting Premium 1. Higher strike price, lower premium on call options and higher premium on put options. 2. Greater term to expiration, higher premiums for both call and put options. 3. Greater price volatility of underlying instrument, higher premiums for both call and put options. 13

Interest-Rate Swap Contract • Notional principle of $1 million • Term of 10 years • Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Company

Hedging with Interest Rate Swaps • Reduce interest-rate risk for both parties 1. Midwest converts $1 m of fixed rate assets to ratesensitive assets, RSA, lowers GAP 2. Friendly Finance RSA, lowers GAP 15

Hedging with Interest Rate Swaps (cont. ) • Advantages of swaps 1. Reduce risk, no change in balance-sheet 2. Longer term than futures or options • Disadvantages of swaps 1. Lack of liquidity 2. Subject to default risk • Financial intermediaries help reduce disadvantages of swaps 16