Download Chapter 1: An Introduction to Corporate Finance

INTRODUCTION TO
CORPORATE FINANCE
SECOND EDITION
Lawrence Booth & W. Sean Cleary
Prepared by Ken Hartviksen & Jared Laneus
Chapter 11
Forwards, Futures, and Swaps
11.1 Forward Contracts
11.2 Futures Contracts
11.3 Swaps
11.4 The Financial Crisis and the Credit Default Swap
Market
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Learning Objectives
11.1 Describe forward contracts and identify the associated
payoffs with long and short positions in forward contracts.
11.2 Explain how simple forward contracts are priced.
11.3 Describe futures contracts and explain why futures contracts
can be viewed as the public market version of forward
contracts.
11.4 Describe the mechanics of simple swap structures, including
interest rate swaps and currency swaps.
11.5 Explain how the credit default swap market contributed to
the financial crisis.
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Forward Contracts
• Derivative securities have price behaviour that is derived from some
underlying asset
• Derivative securities have either linear payoffs, such as forwards,
futures, and swaps, or non-linear payoffs, such as options (Chapter 12)
• Derivatives offer corporations the tools to manage pre-defined risks
and/or capitalize on comparative advantages
• Risks that can be mitigated through derivatives include:
• Foreign exchange risk
• Credit risk
• Interest rate risk
• Because it costs the firm money to engage in derivative positions, the
costs of these practices can be though of as an insurance premium the
firm is willing to pay to reduce (or hedge) its overall exposure to risk
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Spot Versus Forward Contracts
• A spot contract establishes a price today for immediate delivery of an
asset, with the immediacy of the delivery depending on the nature of
the underlying asset
• A forward contract establishes a price today for future delivery on an
asset, and can be specified for almost any future date because forward
contracts are customized contracts between two parties
• Table 11-1 illustrates foreign exchange quotes for spot and future
delivery:
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Forward Contracts
• Like all derivative securities, forwards can be used for:
• Hedging purposes by firms willing to mitigate exposure to specific risks
• Speculating on the future value of some asset in an attempt to profit
• But, in Canada, banks only sell forward contracts for legitimate business
purposes (i.e., for hedging, not for speculation) and only up to a company’s
approved credit limit
• Forward contracts are bank instruments that must be fulfilled
• There is no organized exchange for trading them and instead they are
traded over-the-counter (OTC)
• Forwards require that the customer have a banking relationship and
involves credit risk for the bank when investors suffer losses
• Since forwards are customized instruments, they can be tailored to any
specific date in the future and for any amount of money
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Forward Contracts
• To speculate on a forward contract requires that an investor not own the
underlying asset; this is a “naked” position, where the investor is exposed to
changes in the value of the underlying asset
• Hedging using a forward contract requires that the investor have an
opposite exposure to the contract; this is a “covered” position
• Naked positions expose investors to changes in the value of the underlying
asset
• Long positions are where investors own an asset in the hopes that it will
increase in value and the investor gains by its capital appreciation
• Short positions are where investors owe something. They borrow an asset,
sell it and hope to buy it back at a lower price later. Investors short assets
when they expect the underlying asset to depreciate in price.
• Credit (or counterparty) risk is the risk that a borrower will not fulfill the
contract or make a required payment
• Exposure is the extent to which value is affected by an external event, such
as a change in exchange rates
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Forward Contracts
• Figure 11-1 shows the payoff of a naked or uncovered long position in
the U.S. dollar
• Equation 11-1 shows the profit or loss from a long position as the
difference between the future spot price and the forward price
multiplied by the number of contracts held:
Profit (loss) from long position  ST  F  n
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Forward Contracts
• Figure 11-2 shows the payoff of a short position in the U.S. dollar
• Equation 11-2 shows the profit or loss from a short position as
the difference between the forward price and the future spot
price multiplied by the number of contracts held:
Profit (loss) from long position  F  ST  n
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Forward Contracts
• Figure 11-3 shows the payoffs when a firm with long U.S. dollar exposure
buys a forward contract to sell U.S. dollars forward for Canadian dollars;
the combined position is the sum of the two previous diagrams
• Regardless of what happens to the Canada-U.S. exchange rate, the
company is locked in (or covered, or hedged) against any future
fluctuations in the exchange rate
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Interest Rate Parity (IRP)
• Equations 11-3 and 11-4 express the IRP condition, originally discussed
in Appendix 6A:
1  k domestic 
F 1  k domestic

 F  S

S 1  k foreign
 1  k foreign 
• Example: if the one-year euro interest rate is 3.5%, the one-year
Canadian interest rate is 5%, and today’s spot rate is 1 euro = C$1.50,
what is the one-year forward exchange rate?
1  k domestic 
 1.05 
F  S
 $1.522
  1.50

1.035 
 1  k foreign 
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Interest Rate Parity (IRP) and Pricing
Forward Contracts
• Interest rate parity is a special case for pricing forward contracts
• The general condition is that investors can create a forward position in a
storable commodity by buying it spot and holding it for future delivery
• The only difference between the spot price (S) and the forward price (F)
should be the cost of carry, which is interest costs on financing the
purchase and storage costs of the commodity
• Commodities are things that can be traded based solely on price, because
they are undifferentiated and do not require physical examination
• Storage costs are the price charged for holding a commodity for future
delivery
• Convenience yield is the benefit or premium derived from holding the
asset rather than holding a derivative
• Cost of carry is the total cost of buying a commodity spot and then carrying
it or effecting physical delivery when the forward contract expires
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Pricing Forward Contracts
• Equation 11-5, the commodity pricing model, expresses the relationship
between cost of carry, spot price and forward price:
F = (1 + c) × S
where:
• c = the cost of carry as a percentage of S over the period
• Example: Find the forward price for a one-year forward contract for a
metal that is selling for $90 spot, if storage costs are $5 for the year and
financing costs are 10% per year.
• S = $90, c = (0.1 × $90 + $5) / $90 = 0.1556
• F = (1 + c) × S = (1.1556) × $90 = $104
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Futures Contracts
• Futures contracts are a standardized exchange-traded contract in which the
seller agrees to deliver a commodity to the buyer at some point in the future
• Organized futures exchanges with standardized futures contracts:
• Reduce credit risk by (1) having a clearing corporation act as
counterparty in all transactions, (2) having margin requirements and (3)
marking to market for daily resettlement
• Allow the contract features and volumes to be reported
• Allow the futures positions to be liquid, executing offsetting transactions
to cancel the futures positions, increasing the flexibility in their use
• The term of a futures contract is set by individual exchanges:
• Delivery months are: March, June, September, and December
• Underlying assets are standardized so that even if delivery rarely takes
place, investors know what they’re getting
• The notional amount is standardized for each contract
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Futures Contracts
• For financial futures, most exchanges follow the lead of a major exchange
like the Chicago Mercantile Exchange (CME) Group
• Western barley and canola futures trade on ICE Canada (an exchange)
• Major financial futures contracts like those for bankers’ acceptances (BAX),
two and 10 year Government of Canada bonds (CGZ) and the S&P/TSX 60
Index (SXF) trade on the Montreal Exchange
• Exchanges develop the market in futures contracts and there is significant
competition among exchanges which is a source of innovation:
• New types of contracts are developed
• As interest declines or needs change, some types cease to be traded
• Interest in financial futures has grown substantially as companies
increasingly hedge their risk exposures through these instruments
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Types of Futures Contracts
• Commodity futures, such as traditional agricultural products (corn, wheat,
hogs, etc.), energy products and base metals
• Financial futures, such as the S&P index, bankers’ acceptances, bonds
• Other futures, such as weather derivatives, contracts on real estate,
contracts on the consumer price index (CPI) to hedge inflation
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Marking to Market
• The process of marking to market helps to limit exposure to credit risk
for the exchange
• All futures contracts are marked to market at the end of each day
• Therefore, all profits and losses on a futures contract are credited to
investors’ accounts each day in order to calculate their equity positions
• If the equity position increases, these profits can be withdrawn
• But, if the equity position drops below a maintenance margin, which is
usually 75% of the initial margin, the investor will receive a margin call
and be forced to contribute more money to increase the equity position
back to the maintenance level
• If a margin call is not met in a timely manner, a position can be
liquidated to cover the shortfall
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Trading/Hedging with Futures Contracts
Bond Portfolio Manager Example
• Suppose a fixed-income portfolio manager holds a diversified bond
portfolio comprised primarily of Government of Canada bonds
• The portfolio manager expects interest rates will rise, which will
cause the value of his portfolio to fall because bond prices will fall
• The manager can hedge this interest rate risk by:
1.
2.
Selling bonds and holding cash until the threat of rising rates passes
or until rates actually rise, and then repurchase the devalued bonds.
Sell long term bonds and replace them with shorter maturity bonds,
reducing the portfolio’s duration and mitigating the market value
losses if interest rates actually do rise.
(continued on next slide)
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Trading/Hedging with Futures Contracts
Bond Portfolio Manager Example
(continued)
• The manager can hedge this interest rate risk by:
3. Hold the portfolio unchanged and use a short hedge, a short
position in a government bond futures contract, so the losses in
the market value of the portfolio will be offset by the gains on the
short hedge contract. This avoids the transaction costs and
portfolio disruption of the other two options. But, if the hedge
cannot be perfectly constructed, the portfolio will still have basis
risk because losses on the portfolio may not be exactly offset by
the short hedge.
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Forwards Versus Futures
• Although forward and future contracts serve the same purpose,
forwards offer more flexibility because they are customized contracts
that trade OTC
• Forwards, however, also face more risk, including credit and liquidity
risk.
• Table 11-3 summarizes a comparison of forwards and futures:
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Swaps
• A swap is an agreement between two parties, called
counterparties, to exchange cash flows in the future
• Swaps are not traded on formal exchanges which guarantee
performance, but instead through dealers or over-the-counter, and
there is credit risk
• Swaps have also evolved into bank instruments with banks or swap
dealers serving as intermediaries
• Comparative advantage is a benefit that one firm has relative to
another; for example, the ability to manage a type of risk better
than another firm.
• Interest rate swaps and currency swaps are a common types of
swap.
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Interest Rate Swaps
• An interest rate swap is an exchange of interest payments on a notional
principal amount in which borrows switch loan rates
• Often this involves trading fixed payments for variable rate payments
• A plain vanilla interest rate swap occurs when a fixed-for-floating interest rate
swap is denominated in one currency
• Table 11-4 illustrates a plain vanilla interest rate swap between counterparties
A and B and is structured to benefit both parties equally
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Swaps
• Counterparties to a swap are often unequal partners to the contract; for
example, one party may be AAA-rated while the other is BBB-rated
• Any credit risk is borne by the higher-rated counterparty, so the AAArated party may have to honour both its own obligations and those of
the BBB-rated party if the lower-rated party defaults
• Counterparties can control credit risk by using:
• Set-off rights in the swap agreement allowing the other party to stop
making payments in the event of a default
• Net payments so that, instead of exchanging total interest amounts,
only the difference between the two streams are exchanged and
structuring the payments into sub-periods (e.g., every six months)
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Currency Swaps
• Currency swaps require exchange of all cash flows and permit firms to
adjust their foreign exchange exposure
• This actually increases credit risk, but presents opportunities
• The first swap was a currency swap between IBM Corporation and the
World Bank, motivated by comparative advantage; both IBM and the
World Bank used it to raise new capital cheaply in a primary market
transaction
• Once swaps became standardized, it became possible to change the
nature of the institution’s liability stream constantly
• Today, currency swaps have become a bank market through their links
to the forward foreign exchange market
• Banks are capable of executing a secondary market transaction with
themselves as the counterparties because a currency swap can be
thought of as a series of forward transactions
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Swap Rate
• Standardization has helped to grow the swap market
• Interest rate swaps, like currency swaps, have also become a bank
market through standardization
• Floating rates are fixed against LIBOR (London Inter-Bank Offer Rate)
• Fixed rates are fixed against the government bond rate, with the choice
of rate depending on whether it is a five year, 10 year or other maturity
contract and this becomes the swap rate
• The swap rate is the rate of the fixed portion of a swap which is used
for quoting swaps
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Swap and Forward Market Integration
• Interest rate swaps are found around
the world
• Table 11-7 gives swap rates for the
Euro, U.S. dollar, and Pound Sterling
for May 12, 2009
• Swap rates follow the full spectrum
of the yield curve, from one year to
30 years, so interest rate exposure
can be managed
• It also links swaps to forward rate
agreements (FRAs)
• FRAs are agreements that use
forward rates to manage a firm’s
exposure to interest rate risk by
borrowing or lending at a specified
future date at an interest rate that is
fixed today
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Swap Market Evolution
• The integration of swap markets with the forward market has fuelled
expansion of the market
• Firms wanting to change a floating rate liability into a fixed rate liability,
for example, simply call their bank and execute an interest rate swap as a
secondary market transaction against a line of credit
• Creating swaps is a key component of the services provided by major
banks for their corporate clients
• Swap opportunities beyond interest rate and currency swaps also exist,
including the total return swap
• Total return swaps exchange an interest rate return for the total return on
an equity index plus or minus a spread
• The more specialized a swap is, the less tradable and the greater the
counterparty risk
• Only standardized swaps are done with banks
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The Financial Crisis and the Credit Default
Swap Market
• A total return swap exchanges an interest rate return for the total return
on an equity index plus or minus a spread. For example, first an investor
could enter into an interest rate swap to convert fixed rate bond
payments into payments that vary with a float rate, such as LIBOR. Then,
the investor could enter a total return swap, paying LIBOR and receiving
the total return from an equity index such as the S&P 500 Index.
• The notional principal amount is usually at least $100 million for total
return swaps, so they are used almost exclusively by major financial
institutions and large funds.
• A credit default swap is a swap where one party makes a series of
interest payments and then gets compensated by the counterparty in the
event of default on the bond; it functions as default insurance on a bond.
• An example would be when the risk-free payments on a government
bond are swapped for the proceeds of a risky bond.
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The Financial Crisis and the Credit Default
Swap Market
• There are two important differences between credit default swaps
(CDS) and insurance:
• The risk attached to regular insurance is usually random, and so by
pooling an insurer’s exposure can be made predictable. The risk
underlying CDS is economic or systematic risk which cannot
necessarily be made as predictable as regular insurance.
• The CDS market is part of the swap market (which is an over the
counter market), so everything depends on the counterparties to the
swap fulfilling their obligations. Insurance companies are heavily
regulated and required to keep reserves to ensure they can fulfill
promises.
• By 2007 the CDS market was worth US$45 trillion, or about three times
the value of the entire U.S. stock market.
• Many of the newer CDS contracts were based on securities tied to the
U.S. subprime mortgage market
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The Financial Crisis and the Credit Default
Swap Market
• As the sub-prime market in the United States collapsed in 2007 and 2008,
major issuers of CDS such as American International Group (AIG) were
burdened with fulfilling the contracts as a result of default
• The very solvency of AIG came into question in fall 2008 and the U.S.
government provided funds from the Troubled Asset Relief Program (TARP) to
ensure the continuity of AIG’s counterparty operations
• The failure of AIG also dealt a huge blow to the over-the-counter (OTC)
markets and there is currently pressure to force CDS to be traded on
organized exchanges for greater transparency and to ensure that writers have
to post margins, just like they would for futures contracts, to ensure they can
fulfill their contracts
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Copyright
Copyright © 2010 John Wiley & Sons Canada, Ltd. All rights
reserved. Reproduction or translation of this work beyond that
permitted by Access Copyright (the Canadian copyright licensing
agency) is unlawful. Requests for further information should be
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publisher assume no responsibility for errors, omissions, or
damages caused by the use of these files or programs or from the
use of the information contained herein.
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