Chapter Twenty Three

Hedging with Financial Derivatives

Slide 23–3

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

Slide 23–4

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

• Cons1. Lack of liquidity: hard to

find counter-party

2. Subject to default risk—requires information to screen good from bad risk

Slide 23–5

Financial Futures Markets

• Financial Futures Contract1. 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 pagehttp://www.usafutures.com

Slide 23–6

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

Widely Traded Financial Futures Contracts

Slide 23–8

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)

Slide 23–9

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

Slide 23–10

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

Slide 23–11

Profits and Losses: Options versus Futures

• $100,000 T-bond contract – Exercise price of 115, $115,000

– Premium = $2,000

Interactive calculator for valuing optionshttp://www.intrepid.com/~robertl/option-pricer4.html

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

Slide 23–13

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.

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

Slide 23–15

Hedging with Interest Rate Swaps

• Reduce interest-rate risk for both parties

1. Midwest converts $1m of fixed rate assets to rate-sensitive assets, RSA, lowers GAP

2. Friendly Finance RSA, lowers GAP

Slide 23–16

Hedging with Interest Rate Swaps (cont.)

• Advantages of swaps1. Reduce risk, no change in balance-sheet

2. Longer term than futures or options

• Disadvantages of swaps1. Lack of liquidity

2. Subject to default risk

• Financial intermediaries help reduce disadvantages of swaps