Chapter 22 Managing Financial Risk

1. Chapter 22Managing Financial Risk

2. Derivative Securities • Derive their value from primary securities • Primary financial instrument evidences a direct claim against some other party • Traded in the spot market with prices set by the forces of supply and demand • Put and call options on stocks • Cascade of new derivatives • Require sophisticated computer programming to unravel the complication of many derivatives • Insulate a corporation from different types of risk

3. Hedging Risk • Taking a derivative position opposite to your exposure • Value of the instruments used to hedge do not move in concert • Slight to moderate deviations create basis risk • Use futures contracts, forward contracts, options, or swaps

4. Hedging Fundamentals • Hedge ratio is the ratio of one position relative to the other where risk is neutralized • Must adjust the hedge ratio over time (known as dynamic hedging) if risk is to be minimized • The lower the transaction cost, the more that adjustments can occur and the more that risk is minimized • Requires continual vigilance if risk is to be controlled

5. Arguments for Corporate Hedging • With imperfections hedging may be a thing of value • Reduce total cash-flow and expected cost of bankruptcy • Reduce agency costs • Reduce the problem of underinvestment • May reduce some taxes • Stabilize accounting earnings and reduce the probability of falling below some regulatory requirement • Insulate operating managers from the vagaries of interest-rate changes and currency movements

6. Futures Market • Futures contract is a standardized agreement that calls for delivery of a commodity at some specific future date • With financial futures the commodity is a security • Only a small percentage of contracts come to actual delivery • Buyers and sellers take offsetting positions • Open interest is the number of futures contracts outstanding that have not been closed

7. Several Interest-Rate Futures Markets • Eurodollars • Treasury notes Most important, volume wise • Treasury bonds • Federal funds • 1-month LIBOR • Treasury bills • Municipal bonds

8. Features of Futures Markets • Money market instruments • Margin requirements • Amount of money that must be pledged to cover fluctuations in the market price of the contract, and is subject to daily reset • Initial and maintenance margin requirements • Marked-to-market means daily valuation of a contract with the loser owing money to the winner • Longer-term instruments • Settlement price multiplied by a conversion factor • Established for each coupon rate and time to maturity

9. Hedging and Speculation • Hedging represents taking a futures contract position opposite to a position taken in the spot market to reduce risk exposure • Speculator takes position in futures markets in the pursuit of profits and assumes price risk • Long hedges involves buying a futures contract • Futures market provides a “two-sided” hedge • Short hedges involves writing a contract • Cross hedge

10. Basis Risk • Is the random fluctuation in net position that remains after hedging Future price (adjusted • Basis = Spot market - by appropriate price conversion factor) • Spot price less the futures price should equal the cost of carry • Positive carry • Negative carry

11. Forward Contract • Serves the same economic function as a futures contract but is different in the detail • With interest-rate forward contracts, the forward rate is that rate at which two parties agree to lend and borrow money for a specified period of time in the future • Forward and futures contracts are two sided hedges

12. Forward Nonstandard contract No clearinghouse Over-the -counter Less liquid Settlement at maturity Customized amount More credit risk Futures Standard Clearinghouse Exchange market Liquid Daily settlement Specific size Safer Differences

13. Option Contract • One sided hedges • Debt options • Eurodollars • Treasury bond • Treasury notes • British and German long-term debt • Use of hedge options • Hedge risk or place bets on the direction and/or volatility on interest rates Volume is heaviest

14. Caps, Floors, and Collars • Cap is a put option on a fixed-income security’s value • Floor is a call option • Collar is a combination of a cap and a floor, with variation only in the mid-range • Developed as customized derivative products

15. Valuation of Debt Options • Use option pricing models in the spirit of Black-Scholes • Key is the volatility of returns for the associated asset having to do with the variability of interest rates • Bond’s return variance declines as maturity approaches • When properly modified, the Black-Scholes model gives reasonable explanations of debt option pricing

16. Options on Yield Spreads • Spread is a long-term Treasury interest rate minus a shorter-term rate • All settlements are on a cash basis • Exercise price is expressed in terms of basis points • Option is in the money when the actual yield spread turns out to be greater than the exercise price • Call option holder bets the term structure of interest rates will widen, whereas with a put option it will flatten

17. Interest-Rate Swaps • Exchanges a floating-rate obligation for a fixed-rate one, or vice versa • With a currency swap interest obligations are exchanged in different currencies • With an interest-rate swap, interest-payment obligations are exchanged between two parties denominated in the same currency • Floating-/fixed-rate exchange • A fixed-rate interest payment is exchanged for a floating rate • Basis swap • Two floating-rate obligations are exchanged • Swaps can be customized

18. Swap Valuation Issues • Comparative advantage is a result of imperfections and disparate information • By exploiting market incompleteness in interest-rate management, the swap may benefit all parties • Swaps may allow a party to get around tax laws and regulations

19. Credit Risk • Default risk with respect to differential in interest payments • Intermediaries increasingly interposed themselves between the parties in such a way as to assume the default risk • Replacement risk is that of having to replace a counterparty in case of default • Swap positions can be sold giving them a degree of liquidity not found in many loans • Standardized contract specifies how swaps are to be liquidated in event of default • Margin is not sufficient to compensate for the credit risk if default occurs

20. Secondary Market Values • In a swap sale, a position is sold to another party and there is no further obligation • In a swap reversal, offsetting swaps are sold removing interest rate risk with credit risk remaining • An interest-rate swap is like a series of futures or forward contracts • Mark-to-market is required every day

21. Swaptions • Options that exist for swap transactions • Call swaption, if exercised, involves paying a floating rate and receiving a fixed rate in the swap • Put swaption, if exercised, involves paying a fixed rate and receiving a floating rate • Cancel a swap contract • Futures and forward contracts on swaps

22. Credit Derivatives • Unbundle default risk from the other features of a loan • Can be transferred to others for a price • Protection buyer transfers risk • Protection seller assumes the credit risk and receives a premium for providing the insurance • Credit-swap spread is the periodic premium paid

23. Total Return Swap Protection Buyer Protection Seller Debt instrument’s total return Reference rate +/- spread

24. Credit Swap Premium Protection Buyer Protection Seller No credit event: $0 Credit event: Face value -market value

25. Defining Default, and Liquidity in the Market • Economic default may occur well before legal default • Liquidity in the credit derivative market is limited

26. Other Credit Derivatives • Spread adjusted notes involve resets based on the spread of a particular grade of security over Treasuries • Credit option involves puts and calls based on a basket of corporate fixed-income securities • Credit-sensitive notes involve coupon rate changes when the credit rating changes for the company

27. Commodity Contracts • Agricultural products • Nonagricultural products • Features • Often involve storage costs and perishability • Futures markets • Options on commodity futures • Traded on a number of exchanges • Clearinghouse function • Used by hedgers to shift price risk • Used by speculators to bet on the future course of prices • Principles are the same as for interest-rate contracts