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Chapter 18
Managing Financial Risk with
Derivatives
Order
Placed
Order
Received
< Inventory >
Sale
Payment Sent Cash
Received
Accounts
Collection
< Receivable > < Float >
Time ==>
Accounts
< Payable >
Invoice Received
Disbursement
<
Float
>
Payment Sent
Cash Disbursed
Copyright  2005 by Thomson Learning, Inc.
Learning Objectives
Understand the basic difference between hedging
and speculating.
 Discern between hedging instruments including
futures, options, swaps, and products such as
interest rate ceiling, floor, and collars.
 Develop appropriate interest rate hedging
strategies.

Copyright  2005 by Thomson Learning, Inc.
Hedging vs. Speculating
A hedger has a cash position or an anticipated cash
position that he or she is trying to protect from
adverse interest rate movements
 A speculator has no operating cash flow position to
protect and is trying to profit solely from interest
rate movements

Copyright  2005 by Thomson Learning, Inc.
Some Important Terms
Hedger
 Speculator
 Perfect vs imperfect hedge
 Pure vs anticipatory hedge
 Partial and cross hedge
 Long (buy) and short (sell) hedge
 Mark to market

Copyright  2005 by Thomson Learning, Inc.
Hedger
An entity who uses the futures market to offset the price risks
associated with his basic business activities. By assuming a
position in the futures market that is equal and opposite to his
position in the cash market, the hedger established a situation
where losses in the cash market are offset by gains in the
futures market and vice versa.
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Speculator
An entity who takes a position in the futures market that is not
offset by an opposite position in a basic line of business.
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Perfect vs Imperfect Hedge
A perfect hedge is one where the individual is able to eliminate
all risk of price fluctuations.
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Pure vs Anticipatory Hedge
A pure hedge is one where the individual assumes a position in
the futures market equal and opposite to the current position
in the cash market (such as hedging a riding the yield curve
position).
An anticipatory hedge is taking a position that is a temporary
substitute for an anticipated position in the cash market.
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Partial and Cross Hedge
A partial hedge is where the person takes a position in the
futures market that is smaller than the cash position.
A cross hedge is where the manager uses a different hedging
instrument (futures instrument) than the hedged cash
instrument.
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Long (buy) and Short (sell) Hedge
A long hedge is where the firm BUYS a futures contract.
A short hedge is where the firm SELLS a futures contract.
A long hedge is appropriate when the firm will buy an asset in
the future or sell a liability prior to maturity.
A short hedge is appropriate when the firm issues a liability
in the future or sells a current cash position in the future.
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Mark to Market
Everyday the gain or loss on a futures position causes your
margin account to be adjusted, gains or credited to your
account and losses or debited.
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Hedging With Financial Futures
Introduction
 Buy vs. sell hedge
 Choosing the instrument
 Choosing the expiration date
 Choosing the number of contracts
 Performance evaluation

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Introduction
A standardized contract that carries with it a
performance obligation at expiration
 Margin is generally required and is marked-tomarket daily
 WSJ Quotes
Eurodollar (CME) - $1 mil.; pts of 100%

Open
Open High Low Settle Chg Yield Chg Interest
Mar04 98..84 98.84 98.83 98.83 ... 1.17 ... 835,463
Copyright  2005 by Thomson Learning, Inc.
Buy vs. Sell Hedge
Type of hedge should depend on the nature of the
cash flow position being hedged, not on the
anticipated direction of interest rates.
 Buy Hedge: A future investment or retiring a
liability prior to maturity
 Sell Hedge: Issue a liability in the future or sell an
investment prior to its maturity

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Choosing the Instrument
Choice of instrument should be consistent with the
nature of the cash flow being hedged.
 The interest rates should be highly correlated.

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Choosing the Expiration Date

Choose the contract expiration month that occurs
nearest to, but after, the date of the cash market
transaction to be hedged.
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Choosing the Number of Contracts
Size of cash market instrument
Maturity of cash market instrument
N = ----------------------------------------- x ----------------------------------------------Futures contract denomination
Maturity of futures contract instr.
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Performance Evaluation - Interest
Rate Futures Hedge

Change in the value of the cash position
Face value cash x (SR0 - SR1) x (Matc/360)

Change in the value of the futures position
Face value futures x (FR0 - FR1) x Matf/360)

Commission cost
Number of contracts x Commission rate

Opportunity cost of the margin
Number of contracts x MRG x (D x k/360)
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Performance Evaluation -Currency
Futures Hedge

Change in the value of the spot market position
Face value cash x (CX0 - CX1) = Gain (loss) spot

Change in the value of the futures position
Face value futures x (FX0 - FX1) = Gain (loss)
futures

Commission cost
# contracts x Commission rate = Commission cost

Opportunity cost of the margin
# contracts x MRG x D x (k/360) = Margin cost
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Why Hedges Are Not Perfect

Futures contracts in general have only four
expiration dates per year. (Note T-bills: Mar, June,
Sept, and Dec.

Correlation coefficient of spot rates and futures
rates is less than 1.0
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Hedging With Options
Introduction
 Type of hedge: write or purchase, call or put
 Number of contracts
 Performance evaluation

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Introduction
A call option contract gives the buyer the “right” to
purchase the underlying asset at a specific price,
the striking price, over a specific span of time. The
buyer pays a premium for this right.
 A put option allows the owner to sell the underlying
asset at a specific price over a specific span of time.
The buyer pays a premium for this right.
 The options are on futures contracts for interest
rate instruments

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Type of Hedge: Write or Purchase,
Call or Put
Purchase a call futures option to hedge a future
investment of cash or retire a liability before
maturity.
 Purchase a put futures option to hedge the future
issue of liabilities or the future liquidation of
financial assets.

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Number of Contracts

The number of options needed to purchase is based
directly on the number of futures contracts needed.
Refer to equation 18-1.
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Hedging With Swaps
Introduction
 Interest rate swaps

– Liability swap
– Asset swap

Foreign currency swap
Copyright  2005 by Thomson Learning, Inc.
Introduction
An interest rate swap occurs when two parties agree to
exchange cash flow streams for a specified period of
time. Swaps are different from options and futures in
that they are not generally standardized and their
maturities are usually for longer time periods than
maturities of options and futures.
Copyright  2005 by Thomson Learning, Inc.
Introduction, continued
Interest rate swaps were created to take advantage of arbitrage
opportunities in the various fixed- and floating-rate capital
markets. Arbitrage opportunities exist because some markets
react to change more rapidly than others, because credit
perceptions differ from market to market, and because
receptivity to specific debt structures differs from market to
market. If, for instance, a corporation wants term floating-rate
funds but finds that the market for its fixed-rate debt is comparatively cheaper than that for its floating-rate debt, then it
can issue a fixed-rate bond and swap it into floating, for an
all-in cost lower than that for a floating-rate bond or loan.
source: The Government Securities Pink Book
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Other Details
Notional Amount: the base on which all interest
payments are computed. This amount generally
exceeds $25 million.
 Risks: if the counterparty defaults
 Direct Swap: an agreement between two parties
without the involvement of a financial
intermediary
 Indirect Swap: the agreement is executed through
an intermediary which may assume some of the
credit risk.

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Interest Rate Swap Diagram (Fixedfor-Floating Liability Swap)
Borrows floating rate
debt but desires
$
fixed rate debt
Floating Rate Interest Payments
$
$
$
$
Pays off floating rate
$ debt principal at
maturity
. . . . . . .
Counterparty A
Counterparty A
A pays out fixed rate
to B
$
$
$
$
$
$
$
$
$
$
$
$
B pays out
floating rate to A
. . . . . . .
Counterparty B
Borrows fixed rate
debt but desires
floating rate debt
$
Counterparty B
$
$
$
$
Fixed Rate Interest Payments
$
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Pays off fixed rate
debt principal at
maturity
2005
by Thomson Learning, Inc.
Liability Swap

k swap = fr + so - si + fee
fr = financing rate
so = swap outflow
si = swap inflow
fee = intermediary fee

If fr is fixed rate then so is floating and si is fixed
If fr is floating then so is fixed and si is floating
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Asset Swap

k swap = ir - so + si - fee
ir = investment return
so = swap outflow
si = swap inflow
fee = intermediary fee

If ir is floating rate then so is floating and si is fixed
If ir is fixed rate then so is fixed and si is floating
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A Currency Swap Diagram
Dollar Interest Payments
Borrows pounds
sterling but swaps
for dollars
Re-exchanges $ for
pounds sterling and
pays off debt
. . . . . . .
U. K. Company
U. K. Company
$
£
$
£
$
£
$
£
$
£
$
£
$
£
U. S. Company
Borrows dollars
and swaps for
pounds sterling
$
£
. . . . . . .
U. S. Company
Pound Sterling Interest Payments
Re-exchange £ for
dollars and pays off
debt
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Other Hedging Instruments

Interest rate caps
– Purchaser pays a premium and receives cash payments from the
cap seller when the reference rate exceeds strike rate.
– Cap payment = (ref - strk) x NP x L

Interest rate floors
– Purchaser pays a premium for the rate floor contract, receives
cash payment when reference rate falls below strike rate.
– Floor payment = (strk - ref) x NP x L

Interest rate collars
– Purchase a rate cap and sell or issue a rate floor. Pay a
premium for the cap and receive a premium for the floor.
[Floor payment - Cap payment]
– Effective rate = REF + ----------------------------------------NP
Copyright  2005 by Thomson Learning, Inc.
Summary
The chapter began by discussing the difference
between hedging and speculating.
 The characteristics of different types of derivative
instruments were presented.
 Hedging strategies for each instrument were
developed.
 Each section concluded with a section on how to
evaluate the performance of the hedge.

Copyright  2005 by Thomson Learning, Inc.