25-0

Chapter Twenty Five

Derivatives and Hedging
Risk
Corporate Finance
Ross Westerfield Jaffe
 
25
Sixth Edition

Prepared by
Gady Jacoby
University of Manitoba
and
Sebouh Aintablian
American University of
Beirut
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-1

Chapter Outline
25.1 Forward Contracts
25.2 Futures Contracts
25.3 Hedging
25.4 Interest Rate Futures Contracts
25.5 Duration Hedging
25.6 Swap Contracts
25.7 Actual Use of Derivatives
25.8 Summary & Conclusions

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-2
25.1 Forward Contracts

• A forward contract specifies that a certain

commodity will be exchanged for another at a
specified time in the future at prices specified today.
– It’s not an option: both parties are expected to hold up
their end of the deal.
– If you have ever ordered a textbook that was not in stock,
you have entered into a forward contract.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-3

25.2 Futures Contracts: Preliminaries

• A futures contract is like a forward contract:
– It specifies that a certain commodity will be exchanged
for another at a specified time in the future at prices
specified today.
• A futures contract is different from a forward:
– Futures are standardized contracts trading on organized
exchanges with daily resettlement (“marking to market”)
through a clearinghouse.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-4

Futures Contracts: Preliminaries

• Standardizing Features:
– Contract Size
– Delivery Month
• Daily resettlement
– Minimizes the chance of default
• Initial Margin
– About 4% of contract value, cash or T-bills held
in a street name at your brokerage.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-5

Daily Resettlement: An Example

Suppose you want to speculate on a rise in the US$/¥

exchange rate (specifically you think that the dollar
will appreciate).
Currency per
U.S. $ equivalent U.S. $
Wed Tue Wed Tue
Japan (yen) 0.007142857 0.007194245 140 139
1-month forward 0.006993007 0.007042254 143 142
3-months forward 0.006666667 0.006711409 150 149
6-months forward 0.00625 0.006289308 160 159

Currently US$1 = ¥140.

The 3-month forward price is US$1=¥150.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-6

Daily Resettlement: An Example

• Currently US$1 = ¥140 and it appears that the
dollar is strengthening.
• If you enter into a three-month futures contract to
sell ¥ at the rate of US$1 = ¥150 you will make
money if the yen depreciates. The contract size is
¥12,500,000
• Your initial margin is 4% of the contract value:
US$1
US$3,333.33  .04  ¥12,500,000 
¥150

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-7

Daily Resettlement: An Example

If tomorrow, the futures rate closes at US$1 =
¥149, then your position’s value drops.
Your original agreement was to sell
¥12,500,000 and receive US$83,333.33:
US$1
US$83,333 .33  ¥12,500,000 
¥150
But ¥12,500,000 is now worth US$83,892.62:
US$1
US$83,892.62  ¥12,500,000 
¥149
You have lost US$559.28 overnight.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-8

Daily Resettlement: An Example

• The US$559.28 comes out of your US$3,333.33
margin account, leaving US$2,774.05
• This is short of the US$3,355.70 required for a new
position.
US$1
US$3,355.70  .04  ¥12,500,000 
¥149
Your broker will let you slide until you run through
your maintenance margin. Then you must post
additional funds or your position will be closed out.
This is usually done with a reversing trade.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-9

Selected Futures Contracts

Contract Contract Size Exchange
Agricultural
Corn 5,000 bushels CBOT
Wheat 5,000 bushels CBOT, KBOT,
MPLS
Western Barley 20 metric tons WCE
Orange Juice 15,000 lbs. NYCE
Metals & Petroleum
Gold 100 troy oz. COMEX
Silver 5,000 troy oz. COMEX
Unleaded gasoline 42,000 gal. NYME
Financial
British Pound £62,500 IMM
Japanese Yen ¥12.5 million IMM
Australian Dollar A$100,000 IMM

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-10

Futures Markets

• The Chicago Mercantile Exchange (CME) is by far

the largest.
• In Canada:
– Montreal Futures Exchange (MFE)
– Winnipeg Commodity Exchange (WCE)
• Others include:
– The Philadelphia Board of Trade (PBOT)
– The MidAmerica Commodities Exchange
– The Tokyo International Financial Futures Exchange
– The London International Financial Futures Exchange

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-11

The Winnipeg Commodity Exchange

Canola Futures
• Expiry cycle: January, March, May, July,
September, November.
• First delivery day is the first business day of the
delivery month.
• Last trading day is seven clear business days prior
to the end of the delivery month.
• Trading hours 9:30 a.m. to 1:15 p.m. CT.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-12

The Chicago Mercantile Exchange

• Expiry cycle: March, June, September, December.

• Delivery date third Wednesday of delivery month.
• Last trading day is the second business day
preceding the delivery day.
• CME hours 7:20 a.m. to 2:00 p.m. CST.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-13

CME After Hours

• Extended-hours trading on GLOBEX runs from

2:30 p.m. to 4:00 p.m dinner break and then back at
it from 6:00 p.m. to 6:00 a.m. CST.
• Singapore International Monetary Exchange
(SIMEX) offers interchangeable contracts.
• There are other markets, but none are close to CME
and SIMEX trading volume.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-14
National Post Futures Price Quotes
Highest and lowest prices over the lifetime of the contract.
-Lifetime- -Daily- Prev
High Low Mth Open High Low Settle Chg Op. int

Corn (CBT) Highest price that day

5,000 bushels, US cents per contract; 1/4 cent = $12.5 per contract
270.000 198.500 Mar02 202.500 202.500 199.750 201.500 -1.000 4,709
266.500 205.250 May02 209.250 209.250 206.750 208.250 -1.250 199,466

Canadian Govt. Bonds 10 Year (ME)

$100,000, points of 100%, 0.01 = $10 per contract
Closing price
105.33 100.71 Mar02 103.65 103.68 103.35 103.19 -0.24 12,448
Opening price Daily Change
S&P 500 Composite Index (CME)
250 × index points; 0.10 pt. = $25 per contract
1,705.50 950.30 June02 1,148.50 1,168.50 1,148.50 1,165.00 +13.50 171,082

Lowest price that day

Number of open contracts
Expiry month © 2003 McGraw–Hill Ryerson Limited
McGraw-Hill Ryerson
25-15

Basic Currency Futures Relationships

• Open Interest refers to the number of contracts

outstanding for a particular delivery month.
• Open interest is a good proxy for demand for a
contract.
• Some refer to open interest as the depth of the
market. The breadth of the market would be how
many different contracts (expiry month, currency)
are outstanding.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-16
25.3 Hedging

• Two counterparties with offsetting risks can

eliminate risk.
– For example, if a wheat farmer and a flour mill operator
enter into a forward contract, they can eliminate the risk
each other faces regarding the future price of wheat.
• Hedgers can also transfer price risk to speculators
and speculators absorb price risk from hedgers.
• Speculating: Long vs. Short

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-17

Hedging and Speculating Example

You speculate that copper will go up in price, so you
go long 10 copper contracts for delivery in three
months. A contract is 25,000 pounds in cents per
pound and is at US$0.70 per pound or US$17,500
per contract.

If futures prices rise by 5 cents, you will gain:

Gain = 25,000 × .05 × 10 = US$12,500

If prices decrease by 5 cents, your loss is:

Loss = 25,000 × -.05 × 10 = -US$12,500
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-18
Hedging: How many contacts?
You are a farmer and you will harvest 50,000 bushels
of corn in three months. You want to hedge against a
price decrease. Corn is quoted in U.S. cents per
bushel at 5,000 bushels per contract. It is currently
at 230 cents for a contract three months out and the
spot price is US$2.05.
To hedge you will sell 10 corn futures contracts:
50,000 bushels
 10 contracts
5,000 bushels per contract
Now you can quit worrying about the price of corn
and get back to worrying about the weather.
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-19
25.4 Interest Rate Futures Contracts
• Pricing of Treasury Bonds
• Pricing of Forward Contracts
• Futures Contracts
• Hedging in Interest Rate Futures

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-20

Pricing of Government of Canada Bonds

Consider a Government of Canada bond that pays a
semiannual coupon of $C for the next T years:
– The yield to maturity is r
C C C CF
…
0 1 2 3 2T

Value of the bond under a flat term structure

= PV of face value + PV of coupon payments

F C 1 
PV   1  T 
(1  r ) T
r  (1  r ) 
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-21

Pricing of Government of Canada Bonds

If the term structure of interest rates is not flat, then
we need to discount the payments at different rates
depending upon maturity
C C C CF
…
0 1 2 3 2T
= PV of face value + PV of coupon payments

C C C CF
PV    
(1  r1 ) (1  r2 ) (1  r3 )
2 3
(1  r2T ) T

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-22
Pricing of Forward Contracts
An N-period forward contract on that Government of
Canada Bond
 Pforward C C C CF
…
0 N N+1 N+2 N+3 N+2T
Can be valued as the present value of the forward price.
Pforward
PV 
(1  rN ) N

C C C CF
  
(1  rN 1 ) (1  rN  2 ) (1  rN 3 )
2 3
(1  rN  2T )T
PV 
(1  rN ) N
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-23
Futures Contracts

• The pricing equation given above will be a good

approximation.
• The only real difference is the daily resettlement.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-24
Hedging in Interest Rate Futures

• A mortgage lender who has agreed to loan money in

the future at prices set today can hedge by selling
those mortgages forward.
• It may be difficult to find a counterparty in the
forward who wants the precise mix of risk,
maturity, and size.
• It’s likely to be easier and cheaper to use interest
rate futures contracts however.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-25
25.5 Duration Hedging
• As an alternative to hedging with futures or
forwards, one can hedge by matching the interest
rate risk of assets with the interest rate risk of
liabilities.
• Duration is the key to measuring interest rate risk.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-26
25.5 Duration Hedging
• Duration measures the combined effect of maturity,
coupon rate, and YTM on bond’s price sensitivity
– Measure of the bond’s effective maturity
– Measure of the average life of the security
– Weighted average maturity of the bond’s cash
flows

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-27

Duration Formula

PV (C1 ) 1  PV (C2 )  2    PV (CT )  T

D
PV
N
Ct  t
 (1  r ) t
D  tN1
Ct

t 1 (1  r ) t

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-28

Calculating Duration

Calculate the duration of a three-year bond that

pays a semi-annual coupon of $40, has a $1,000
par value when the YTM is 8% semiannually.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-29

Calculating Duration
Discount Present Years x PV
Years Cash flow factor value / Bond price

0.5 $40.00 0.96154 $38.46 0.0192

1 $40.00 0.92456 $36.98 0.0370
1.5 $40.00 0.88900 $35.56 0.0533
2 $40.00 0.85480 $34.19 0.0684
2.5 $40.00 0.82193 $32.88 0.0822
3 $1,040.00 0.79031 $821.93 2.4658
$1,000.00 2.7259 years
Bond price Bond duration
Duration is expressed in units of time; usually years.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-30
Duration

The key to bond portfolio management

• Properties:
– Longer maturity, longer duration
– Duration increases at a decreasing rate
– Higher coupon, shorter duration
– Higher yield, shorter duration
• Zero coupon bond: duration = maturity

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-31

25.6 Swaps Contracts: Definitions

• In a swap, two counterparties agree to a

contractual arrangement wherein they agree to
exchange cash flows at periodic intervals.
• There are two types of interest rate swaps:
– Single currency interest rate swap
• “Plain vanilla” fixed-for-floating swaps are often just
called interest rate swaps.
– Cross-currency interest rate swap
• This is often called a currency swap; fixed for fixed
rate debt service in two (or more) currencies.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-32

The Swap Bank

• A swap bank is a generic term to describe a

financial institution that facilitates swaps between
counterparties.
• The swap bank can serve as either a broker or a
dealer.
– As a broker, the swap bank matches counterparties but
does not assume any of the risks of the swap.
– As a dealer, the swap bank stands ready to accept either
side of a currency swap, and then later lay off their risk, or
match it with a counterparty.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-33

An Example of an Interest Rate Swap

• Consider this example of a “plain vanilla” interest

rate swap.
• Bank A is a AAA-rated international bank located in
the U.K. and wishes to raise US$10,000,000 to
finance floating-rate eurodollar loans.
– Bank A is considering issuing five-year fixed-rate
eurodollar bonds at 10-percent.
– It would make more sense to for the bank to issue
floating-rate notes at LIBOR to finance floating-rate
eurodollar loans.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-34

An Example of an Interest Rate Swap

• Firm B is a BBB-rated U.S. company. It needs

US$10,000,000 to finance an investment with a
five-year economic life.
– Firm B is considering issuing five-year fixed-rate
eurodollar bonds at 11.75-percent.
– Alternatively, firm B can raise the money by issuing five-
year floating-rate notes at LIBOR + 0.5-percent.
– Firm B would prefer to borrow at a fixed rate.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-35

An Example of an Interest Rate Swap

The borrowing opportunities of the two firms are:

COMPANY B BANK A

Fixed rate 11.75% 10%

Floating rate LIBOR + .5% LIBOR

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-36

An Example of an Interest Rate Swap

Swap The swap bank makes this

offer to Bank A: You pay
Bank LIBOR – 0.125% per year
10.375%
on US$10 million for five
LIBOR – 0.125% years and we will pay you
Bank 10.375% on US$10
million for five years
A

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-37

An Example of an Interest Rate Swap

0.5% of US$10,000,000 =
US$50,000. That’s quite a
Swap Here’s what’s in it for Bank A:
cost savings per year for
They can borrow externally at
five years.
Bank 10% fixed and have a net
10.375% borrowing position of

LIBOR – 0.125% -10.375% + 10% + (LIBOR –

0.125%) = LIBOR – 0.5% which
Bank is 0.5% better than they can
10% borrow floating without a swap.
A

COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-38

An Example of an Interest Rate Swap

The swap bank
makes this offer to
Swap
company B: You
pay us 10.5% per Bank
year on US$10 10.5%
million for five LIBOR – 0.25%
years and we will Company
pay you LIBOR –
0.25% per year on B
US$10 million for
COMPANY B BANK A
five years.
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-39

An Example of an Interest Rate Swap

Here’s what’s in it for B:

0.5 % of US$10,000,000
Swap = US$50,000 that’s quite
a cost savings per year for
Bank
five years.
They can borrow externally at 10.5%

LIBOR + 0.5 % and have a net LIBOR – 0.25%

borrowing position of Company LIBOR

+ 0.5%
10.5 + (LIBOR + 0.5 ) - (LIBOR – 0.25 ) = B
11.25% which is 0.5% better than they can borrow
floating. COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-40

An Example of an Interest Rate Swap

The swap bank makes money too. 0.25% of US$10
Swap million = US$25,000
per year for five years.
Bank
10.375% 10.5%

LIBOR – 0.125% LIBOR – 0.25%

Bank LIBOR – 0.125 – [LIBOR – 0.25]= 0.125 Company
A 10.5 – 10.375 = 0.125 B
0.250
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-41

An Example of an Interest Rate Swap

The swap bank makes 0.25%
Swap
Bank
10.375% 10.5%

LIBOR – 0.125% LIBOR – 0.25%

Bank Company
A B
A saves 0.5% B saves 0.5%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-42

An Example of a Currency Swap

• Suppose a U.S. MNC wants to finance a £10,000,000
expansion of a British plant.
• They could borrow dollars in the U.S. where they are well
known and exchange dollars for pounds.
– This will give them exchange rate risk: financing a
sterling project with dollars.
• They could borrow pounds in the international bond market,
but pay a premium since they are not as well known abroad.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-43

An Example of a Currency Swap

• If they can find a British MNC with a mirror-image
financing need they may both benefit from a swap.
• If the spot exchange rate is S0($/£) = US$1.60/£, the U.S.
firm needs to find a British firm wanting to finance dollar
borrowing in the amount of US$16,000,000.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-44

An Example of a Currency Swap

Consider two firms A and B: firm A is a U.S.-based
multinational and firm B is a U.K.-based multinational.
Both firms wish to finance a project in each other’s country of
the same size. Their borrowing opportunities are given in the
table below.

US$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-45

An Example of a Currency Swap

Swap
Bank US$9.4%
US$8%

£11% £12%
US$8% Firm Firm £12%
A B

US$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-46

An Example of a Currency Swap

A’s net position is to borrow at £11%
Swap
Bank
US$8% US$9.4%

£11% £12%
US$8% Firm Firm £12%
A B
A saves £.6%
US$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-47

An Example of a Currency Swap

B’s net position is to borrow at US$9.4%
Swap
Bank
US$8% US$9.4%

£11% £12%
US$8% Firm Firm £12%
A B

US$ £ B saves $.6%

Company A 8.0% 11.6%
Company B 10.0% 12.0%

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-48

An Example of a Currency Swap

1.4% of US$16 million
The swap bank makes money too:
financed with 1% of
Swap £10 million per year for
Bank five years.
US$8% US$9.4%

£11% £12%
US$8% Firm At S0($/£) = $1.60/£, that Firm £12%
A is a gain of US$124,000 B
per year for 5 years.
The swap bank
US$ £ faces exchange rate
Company A 8.0% 11.6% risk, but maybe
Company B 10.0% 12.0% they can lay it off
(in another swap).
McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited
25-49

Variations of Basic Swaps

• Currency Swaps
– fixed for fixed
– fixed for floating
– floating for floating
– amortizing
• Interest Rate Swaps
– zero-for floating
– floating for floating
• Exotica
– For a swap to be possible, two humans must like the idea.
Beyond that, creativity is the only limit.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-50

Risks of Interest Rate and Currency Swaps

• Interest Rate Risk

– Interest rates might move against the swap bank after it
has only gotten half of a swap on the books, or if it has an
unhedged position.
• Basis Risk
– If the floating rates of the two counterparties are not
pegged to the same index.
• Exchange Rate Risk
– In the example of a currency swap given earlier, the swap
bank would be worse off if the pound appreciated.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-51

Risks of Interest Rate and Currency Swaps

• Credit Risk
– This is the major risk faced by a swap dealer—the risk
that a counter party will default on its end of the swap.
• Mismatch Risk
– It’s hard to find a counterparty that wants to borrow the
right amount of money for the right amount of time.
• Sovereign Risk
– The risk that a country will impose exchange rate
restrictions that will interfere with performance on the
swap.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-52

Pricing a Swap

• A swap is a derivative security so it can be priced in

terms of the underlying assets:
• How to:
– Plain vanilla fixed for floating swap gets valued just like
a bond.
– Currency swap gets valued just like a nest of currency
futures.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-53

25.7 Actual Use of Derivatives

• Because derivatives don’t appear on the balance sheet, they
present a challenge to financial economists who wish to
observe their use.
• Survey results appear to support the notion of widespread
use of derivatives among:
– large publicly traded firms,
– Canadian multinational companies,
– nonregulated companies,
– gold and silver, paper and forest, pipelines, and agricultural
companies.
• Foreign currency and interest rate derivatives are the most
frequently used.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited

25-54
25.8 Summary & Conclusions
• This chapter shows a number of hedging strategies.
• A short hedge involves an agreement to sell the
underlying asset in the future.
• A long hedge involves an agreement to buy the
underlying asset in the future.
• Swaps can also be used to hedge; a swap can be
viewed as a portfolio of futures with different
maturities.

McGraw-Hill Ryerson © 2003 McGraw–Hill Ryerson Limited