Transcript ch23_final.ppt

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
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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
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• 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
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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. Hedging similar to forwards: micro versus macro hedge
• Traded on Exchanges
Commodity Futures Options Trading, Inc. home page
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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
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Financial Futures Contracts (cont.)
• Interest Rate Futures
• Stock Index Futures
• Currency Futures
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Widely Traded Financial Futures Contracts
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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)
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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
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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
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Profits and Losses: Options versus Futures
• $100,000 Canada-bond contract
– Exercise price of 115, $115,000
– Premium = $2,000
Interactive calculator for valuing options
www.intrepid.com/~robertl/option-pricer4.html
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Figure 1: Profits and Losses on Options
versus Futures Contracts
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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.
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Interest-Rate Swap Contract
• Notional principle of $1 million
• Term of 10 years
• First Trust swaps 7% payment for T-bill + 1%
from Friendly Finance Company
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Hedging with Interest Rate Swaps
• Reduce interest-rate risk for both parties
1. First Trust converts $1m of fixed rate assets to ratesensitive assets, RSA, lowers GAP
2. Friendly Finance RSA, lowers GAP
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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
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