Download Contemporary Logistics n Enterprise Financing

Contemporary Logistics 07 (2012) 1838-739X
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Contemporary Logistics
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Research on the Application of Financial Derivatives in Enterprise
Financing
Xin TANG1, 2,*, Zhen WANG1, 2
1. Institute of Agricultural Economics and Development, Chinese Academy of Agricultural Sciences, 100081,
P.R.China
2. College of Economics and Management, Hebei Polytechnic University, 063009, China
KEYWORDS
ABSTRACT
Financial derivatives,
Enterprise financing,
Financial forwards,
Financial futures,
Financial options,
Financial swaps
Enterprises are facing a lot of problems, one of which is the financing difficulty that is quite
outstanding and hard to be resolved. The thesis mainly researches the application theory of
financial derivatives such as financial forwards, financial futures, financial options and
financial swaps in finance enterprise, and analyzes some cases in details. When considering
financial derivatives in finance, enterprises could expand the financing methods and reduce
financing costs, which will be an effective way to solve financing problems.
© ST. PLUM-BLOSSOM PRESS PTY LTD
Introduction
Financing difficulty is a significant issue for most enterprises which is restricting the enterprises’ further development. There are
many reasons which including the enterprises themselves and external environment. Among them, the single financing means has
been a prominent reason in recent years. Actively introduction of a variety of financing means, especially financial derivatives, will
be an effective way to solve the problem. Enterprises using financial derivatives in financing, can expand the financing means,
reduce financing costs, and select the favorable financing opportunity.
Financial derivatives are financial instruments that “derive” value from an underlying item such as an asset or index. The us e of
derivatives provides exposure to the linked underlying item without necessitating the trade or exchange of the item itself. This allows
specific risks, such as commodity or equity price fluctuations to be traded in financial market [1]. The main purposes of derivatives are
risk control, arbitrage, and speculation. Derivatives allow risk of the underlying asset or index to be transferred between entities. It is
relatively little in research and application on enterprise financing .
Main financial derivatives are as follows:
Financial forwards - An agreement to buy or sell a financial asset at a certain time in the future for a certain price.
Financial futures - Contracts to buy or sell a financial asset at a specific future date. Futures are essentially standardized forward
contracts.
Financial options - Contracts give holder the right but not the obligation to buy or sell a financial asset as a specific future date.
*
Corresponding author.
Email: [email protected]
English edition copyright © ST. PLUM-BLOSSOM PRESS PTY LTD
DOI: 10.5503/J.CL.2012.07.012
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Financial swaps - An agreement to exchange cash flows at a specified time according to certain rules.
2 Financial Forwards in the Application of Enterprise Financing
Financial forward contracts mainly include forward rate agreements, forward foreign exchange contracts and forward equity
contracts. Forward rate agreements are mainly used in enterprise financing.
A Forward Rate Agreement (FRA) is a forward contract in which one party pays a fixed interest rate, and receives a floating interest
rate equal to a reference rate (the underlying rate). The payments are calculated over a notional amount over a certain period, and
netted; i.e. only the differential is paid. It is paid on the effective date. The reference rate is fixed one or two days before the effective
date, dependent on the market convention for the particular currency [2]. FRAs are usually used to protect the borrower against rising
interest rates. The purpose of a FRA is to guarantee the future interest rate, and there is no direct link between the FRA and the
underlying loan.
In most cases, enterprises need to borrow a certain amount of funds or hold a large amount of debt in future time, but the future of
interest rates is uncertain. Enterprises can bring forward rate agreements so as to avoid risk of rising interest rates and lock in
financing costs. If market interest rates rising on maturity date, enterprises can follow as a lower interest rate to borrow money
contract, so that enterprises can control financing costs to some extent and reduce risk.
The whole process can be described as Figure 1shown.
Lag period
Contract period
2 Days
Dealing date
Fixing date
Settlement date
Maturity date
Figure 1 Flow Chart of FRA
The Fixed Rate is the rate at which the contract is agreed on dealing date.
The Reference Rate is typically Euribor or LIBOR which is the rate on fixing date.
α is the day count fraction, i.e. the portion of a year over which the rates are calculated, using the day count convention used in the
money markets in the underlying currency. For EUR and USD, this is generally the number of days divided by 360, for GBP it is the
number of days divided by 365 days [3].
If the reference rate of interest exceeds the contract rate, then the seller must pay the buyer a sum of payments to compensate the
buyer in the result of rising interest rates in loan losses. Settlement payment is calculated as follows:
Contract amount*(Reference Rate- Fixed Rate)* α
Settlement payment =
(1)
1+ Reference Rate* α
Assuming one company as a multinational company, the business needs is one million U.S. D financing in October. The company
makes a “1 × 4” FRA which one million U.S. dollars contract on behalf of a 4.75% interest rate with another agency. Reference
interest rate is 5.50%.
Settlement payment =
 0.055  0.0475 1000000 
91 

1   0.055 

360 

91
360 =1869.84 (USD)
(2)
As 5.50% > 4.75%, so the agency as a seller must pay the company's settlement payment to compensate the buyer in the rising loan
losses.
From this case, using FRAs to finance, enterprises can control financing costs and reduce the risk of financing.
3 Financial Futures in the Application of Enterprise Financing
In finance, a futures contract is a standardized contract between two parties to buy or sell a specified asset of standardized quantity
and quality at a specified future date at a price agreed today. Futures contracts are not "direct" securities like stocks, bonds, rights or
warrants. They are still securities; however, they are a type of derivative contract. The party agreeing to buy the underlying asset in
the future assumes a long position, and the party agreeing to sell the asset in the future assumes a short position.
In many cases, the underlying asset to a futures contract may not be traditional "commodities" at all – that is, for financial futures, the
underlying asset or item can be currencies, securities or financial instruments and intangible assets or referenced items such as
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interest rates and stock indexes.
The Theory of Financial Futures in the application on enterprise financing is as follows. If the financial manager expects that the
interest rate or exchange rate will increase when loans repay at fixed cost, he inevitably want to prevent the interest rate risk or
exchange rate risk. In this case, the enterprise may buy the corresponding futures contracts, when the contract expires and then sell
the contract to achieve the purpose of preservation.
Suppose that a company's U.S. subsidiary corporation A borrow £100, 000 on May 1, and repayment period is November 1.
Corporation A in the foreign exchange market at the spot exchange rate £1 = 2 U.S. dollars to 100, 000.00 pounds into dollars, they
hope the dollar exchange rate into pounds when repay the loan after 6 months at the fixed costs. Corporation A can buy pound futures
contract and then sell the contract after 6 months to achieve the purpose of preservation. Table 1 shows the calculation:
Table 1 Futures Hedging
May 1
Spot Market
Futures Market
Borrow £100,000 and sold pound according
By exchange rate £1 = 1.95 U.S. dollars to
to 2 U.S. dollars= £1
buy four copies of the pound in December
delivery futures contracts, each contract is
25,000 pounds
November 1
To buy back £100,000 according to £1 =
By exchange rate £1 = 2 U.S. dollars to sold
2.05 U.S. dollars
four copies of the pound in December
delivery futures contracts
Loss is USD 5,000
Profit is USD 5,000
Note: Basis Risk and charges are negligible.
From table 1, we can see that the company break even in the spot market and futures market, and achieve the purpose of avoiding
risk of exchange rate.
4 Financial Options in the Application of Enterprise Financing
In finance corporations, option is a financial instrument that gives the right to its owner, but not the obligation to engage in some
specific transaction on an asset. Options are derivative instruments, as their fair price derives from the value of the other asset, called
the underlying. The underlying is commonly a stock, a bond, a currency or a futures contract, though many other types of options
exist, and options can in principle be created for any type of valuable asset [4].
Different from futures, rights and obligations of the option parties is asymmetric. The buyer's maximum loss is only the option
premium. That is to say, when the underlying asset is at risk, you can pay a premium to buy options to hedge in the options market. If
the price is unfavorable, while hedgers can to avoid losses through the implementation of options and if the price is favorable change,
hedgers can also benefit by giving up options.
In corporation financing, it is necessary to fix the financing costs in order to avoid the loss when the interest rate or exchange rate
changing on the date of repayment of loans. Therefore, enterprises can purchase the appropriate call in advance and pay a premium.
On the maturity date , if the interest rate or exchange rate rises, enterprises can exercise the option; if interest rates or the exchange
rate declines, enterprises can give up the option; If the interest rate or exchange rate remain unchanged, enterprises can exercise the
option or not exercise the option, but the maximum loss is the premium.
As the above case, assuming that corporation A chooses the option to fix the cost of credit. It purchases 8 call options in advance
which option premium is 0.01 U.S. dollars per pound. It is £1, 000 for 8 options to pay. Protocol exchange rate is £1 = 2 U.S. dollars.
So, corporation A pays 1,000 U.S. dollars for an option which allows the company to buy 10 million pounds by the agreement
exchange rate at any time within 6 months. After 6 months, the following phenomena will occur in any of three conditions: the pound
would be appreciated, as 1 pound = 2.05 U.S. dollars; the pound would be depreciated, as 1 pound = 1.95 U.S. dollars; the last
probability is the exchange rate is unchanging, still £1 = 2 U.S. dollars.
Situation 1: pound appreciateed to £1 = 2.05 U.S. dollars. If not buy options, the company should pay 205,000 U.S. dollars, but the
executed option is the company can buy pounds under the agreement of £1 pound = 2 U.S. dollars. Compared with market exchange
rate, it will pay less than 5,000 U.S. dollars, excluding option costs for 1000 U.S. dollars, but also costs 4000 U.S. dollars.
Situation 2: pound depreciated to £1 = 1.95 U.S. dollars. The company is able to give up the option and purchase pounds at market
exchange rates. The company only pays 195 thousand U.S. dollars, plus option cost of 1000 U.S. dollars, a total of which is only 196
thousand U.S. dollars, and 4,000 U.S. dollars saved.
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Situation 3: exchange rate remains unchanged. The company can exercise the option, or also can not exercise the option and buy
pound according to market exchange rate directly. The biggest loss is 1000 U.S. dollars. The company doesn't suffer any loss of
exchange rate changes.
From the above analysis, it shows that company A, as a buyer of the option, can actually be seen as the "insurance" business in
financing costs by purchasing options.
5 Financial Swaps in the Application of Enterprise Financing
Interest rate swaps are applied widely in corporation financing. What does Interest Rate Swap mean? Generally speaking, an
agreement between two parties (known as counterparties) that one stream of future interest payments is exchanged for another based
on a specified principal amount. Interest rate swaps often exchange a fixed payment for a floating payment that is linked to an
interest rate (most often the LIBOR). A company will typically use interest rate swaps to limit or manage exposure to fluctuations in
interest rates, or to obtain a marginally lower interest rate than it would have been able to get without the swap [5].
The main reason for two sides of interest rate swaps is that both fixed-rate payer and floating-rate payers have a comparative
advantage. It is easily for companies with high credit ratings to borrow money at fixed interest rate, while the same as companies
with low credit ratings to borrow loans at floating rate easily.
The interest rate swap gives the less creditworthy entity a way of borrowing fixed rate funds for a longer term at a cheaper rate than
they could raise such funds in the capital markets by taking advantage of the entity's relative advantage in raising funds in the shorter
maturity buckets .
The article gives an example. Company A and B both want to borrow 10 million U.S. dollars in loans within five years. Those two
companies with different credit ratings, thus the market interest rate is not available to both of them, as shown in Table 2.
Table 2 The market interest rate of Company A and Company B
Fixed rate
Floating rate
Company A
10.00%
6-month USD Libor +0.30%
Company B
11.20%
6-month USD Libor +1.00%
An interest rate swap can be described as follows:
Terms:
Fixed rate payer: Company B
Fixed rate: 9.95 percent, annual
Floating rate payer: Company A
Floating rate: 6-month USD Libor
Notional amount: US$ 10 million
Maturity: 5 years
Interest rate swaps process shown in Figure 2.
Fixed rate payment
(9.95% .a.)
Company A
Company B
Floating rate payment
(6-month Libor)
Figure 2 Flow chart of interest rate swaps
Both sides of transactions benefit from the swap. Table 3 shows the financing cost of Company A and Company B.
Table 3 The financing cost of Company A and Company B
No Swap
Through
Swap
Save
Company A
Company B
6-month USD Libor +0.30%
11.20%
6-month USD Libor +0.05%
10.95%
0.25%
0.25%
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Through this interest rate swap, the overall financing costs are reduced by 0.5% (11.20% + 6-month LIBOR +0.03% -10.00% - 6
month LIBOR-1.00%). Assumption that both sides share half of each, then both sides will reduce the financing costs of 0.25%.
Interest rate swap only be used to exchange the interest differents not to involve the principal; therefore, the credit risk is not as
maximum as possible.
6 Conclusion
There is a large application space in enterprise financing for financial derivatives. Enterprises can control the financing cost and
reduce the financial risk by utilizating derivatives. The financial forwards and financial futures can help enterprise lock in the
financing cost at the right time, financial options can be beneficial to retaining the favorable risks; meanwhile, financial swaps can
reduce the cost of financing in both sides so as to avoid adverse risks and achieve win-win situation. Of course, enterprises can also
use a variety of derivative instruments with the purpose of better achieve enterprises’ financial goals.
References
[1]. ZHANG Yuanping. Financial Derivatives Tutorial. Beijing: Capital University of Economics and Business Press. 2003, p1-4 (in
Chinese)
[2]. Forward rate agreement, http://en.wikipedia.org/wiki/Forward_rate_agreement
[3]. MAO Erwan. Introduction of financial engineering.Beijing: China Machine Press, 2006, p27-28 (in Chinese)
[4]. John F. Mashall. Futures and Option Contracting. South-western Publishing Co.,1989, p2-4
[5]. Interest Rate Swap Definition, http://www.investopedia.com/terms/i/interestrateswap.asp
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