Download The Research on Application of Financial Derivatives in Enterprise Financing

ORIENT ACADEMIC FORUM
The Research on Application of Financial Derivatives in Enterprise
Financing
TANG Xin1,2, WANG Zhen1,2
1. Institute of Agricultural Economics and Development, Chinese Academy of Agricultural Sciences,
P.R.China, 100081
2.College of Economics and Management, Hebei Polytechnic University, China, 063009
[email protected]
Abstract: Enterprises face a lot of problems, one of which is the difficulty of financing. It 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
enterprise financing, and analyzes the cases in detail. When considering financial derivatives in
financing , enterprises could expand the financing means and reduce the financing costs. It will be an
effective way to solve the problem of financing.
Keywords: Financial derivatives, enterprise financing, financial forwards, financial futures, financial
options, financial swaps
1 Introduction
It is an important issue for the most enterprises that it‘s difficult in financing, which is restricting the
enterprises’ further development. There are many reasons, both in the enterprises themselves, but also in
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 use 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 following:
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.
Financial swaps - An agreement to exchange cash flows at a specified time according to certain rules.
2 Financial Forwards in the Application in 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,
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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 1.
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
An example is taken:
Assume that a company is a multinational company, and the business needs of one million U.S. dollars
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%.
( 0.055 − 0.0475) ×1000000 ×
Settlement payment =
91 

1 +  0.055 ×

360 

91
360 =1869.84 (USD)
(2)
As 5.50%> 4.75%, so the agency as a seller must pay to 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 in 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, though 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.
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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 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 A on May 1 borrow £ 100 000 and repayment period is
November 1. A company in the foreign exchange market at the spot exchange rate £ 1 = 2 U.S. dollars to
one hundred thousand pounds into dollars, they hope the dollar exchange rate into pounds when repay
the loan after 6 months at the fixed costs. A company 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
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
May 1
delivery futures contracts, each contract is
25 000 pounds
To buy back £ 100 000 according to £ 1 = By exchange rate £ 1 = 2 U.S. dollars to
November 1
2.05 U.S. dollars
sold 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 can be seen 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 in Enterprise Financing
In finance, an option is a financial instrument that gives its owner the right, 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 options 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 corporate 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 company A chooses the option to fix the cost of credit. Company A
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, company A pay 1,000 U.S.
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dollars for an option that allows the company to buy 10 million pounds by the agreement exchange rate
at any time within 6 months. After 6 months the following will occur in any of three conditions: one for
the pound appreciated, as 1 pound = 2.05 U.S. dollars; the other for the pound depreciated, as 1 pound =
1.95 U.S. dollars; the third for the exchange rate 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 with the options executed, the company can buy pounds under the
agreement £ 1 pound = 2 U.S. dollars. Compared to market exchange rate, it will pay less 5,000 U.S.
dollars, excluding option costs 1000 U.S. dollars, but also costs 4000 U.S. dollars.
•
Situation 2: pound depreciated to £ 1 = 1.95 U.S. dollars. The company can 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.
•
Situation 3: exchange rate remains unchanged. The company can exercise the option, or can
also 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 in Enterprise Financing
Interest rate swaps are applied widely in corporate financing. What Does Interest Rate Swap Mean?
Generally speaking, an agreement between two parties (known as counterparties) where 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 Company B both want to borrow 5-year 10 million U.S.
dollars in loans. Company A wish but the two companies with different credit ratings, so the market
interest rate available to them is also different, as shown in Table 2.
Table 2 The market interest rate available to 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
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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.
No Swap
Through
Swap
Save
Table 3 The Financing Cost of Company A and Company B
Company A
Company B
6-month USD Libor +0.30%
11.20%
6-month USD Libor +0.05%
10.95%
0.25%
0.25%
Through this interest rate swap, the overall financing costs is reduced by 0.5% (11.20% + 6-month
LIBOR +0.03% -10.00% -6 month LIBOR-1.00%), which is the interests in this swap. Assumption that
both sides share half of each, then both sides will reduce the financing costs of 0.25%.
Interest rate swap only to exchange the interest differential, does not involve the principal, so the credit
risk is minimal.
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, avoiding adverse risks; financial swaps can
reduce the cost of financing both sides in order to achieve win-win situation. Of course, enterprises can
also use a variety of derivative instruments so as to better achieve enterprises’ financial goals.
References
[1]. Zhang yuanping. Financial Derivatives Tutorial. Beijing: Capital University of Economics and
Business Press.2003,p 1-4(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,p 27-28 (in
Chinese)
[4]. John F.Mashall.Futures and Option Contracting.South-western Publishing Co.1989, p 2-4
[5]. Interest Rate Swap Definition,http://www.investopedia.com/terms/i/interestrateswap.asp
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