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Chapter 22 Managing Financial Risk . 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

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derivative securities
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
hedging risk
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
hedging fundamentals
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
arguments for corporate hedging
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
futures market
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
several interest rate futures markets
Several Interest-Rate Futures Markets
  • Eurodollars
  • Treasury notes Most important, volume wise
  • Treasury bonds
  • Federal funds
  • 1-month LIBOR
  • Treasury bills
  • Municipal bonds
features of futures markets
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
hedging and speculation
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
basis risk
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
forward contract
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

Nonstandard contract

No clearinghouse

Over-the -counter

Less liquid

Settlement at maturity

Customized amount

More credit risk




Exchange market


Daily settlement

Specific size


option contract
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

caps floors and collars
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
valuation of debt options
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
options on yield spreads
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
interest rate swaps
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
swap valuation issues
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
credit risk
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
secondary market values
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
  • 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
credit derivatives
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
total return swap
Total Return Swap





Debt instrument’s total return

Reference rate +/- spread

credit swap
Credit Swap






No credit event: $0

Credit event: Face value

-market value

defining default and liquidity in the market
Defining Default, and Liquidity in the Market
  • Economic default may occur well before legal default
  • Liquidity in the credit derivative market is limited
other credit derivatives
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
commodity contracts
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