FINANCIAL MANAGEMENT
THEORY & PRACTICE
ADAPTED FOR THE SECOND CANADIAN
EDITION BY:
JIMMY WANG
LAURENTIAN
UNIVERSITY
CHAPTER 21
DERIVATIVES AND RISK
MANAGEMENT
CHAPTER 21 OUTLINE
•
•
•
•
•
•
Reasons to Manage Risk
Background on Derivatives
Derivatives in the News
Other Types of Derivatives
Corporate Risk Management
Using Derivatives to Reduce Risks
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Reasons to Manage Risk
1. Debt Capacity
Risk management can reduce the volatility of
cash flow, which decreases the probability of
bankruptcy.
Firms with lower operating risks can use more
debt, and this can lead to higher stock prices
due to the interest tax savings.
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Reasons to Manage Risk (cont’d)
2. Maintaining the optimal capital budget over
time.
In bad years, internal cash flows may be too low to
support the optimal capital budget, causing
firms to either slow investment below the
optimal rate or else incur the high costs
associated with external equity. By smoothing
out the cash flows, risk management can
alleviate this problem.
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Reasons to Manage Risk (cont’d)
3. Financial distress
Any serious level of financial distress causes a
firm to have lower cash flows than expected.
Risk management can reduce the likelihood
of low cash flows, hence of financial distress.
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Reasons to Manage Risk (cont’d)
4. Comparative advantages in hedging
Most investors cannot hedge as efficiently as a
company. Firms generally have lower
transactions costs due to a larger volume of
hedging activities. Managers know more
about the firm’s risk exposure than outside
investors. Firms are more likely to have those
specialized skills and knowledge required by
effective risk management.
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Reasons to Manage Risk (cont’d)
5. Borrowing costs
Any cost reduction adds value to the firm.
Firms can sometimes reduce input costs,
especially the interest rate on debt, through
the use of derivative instruments called
“swap.”
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Reasons to Manage Risk (cont’d)
6. Tax effects
Using risk management to stabilize earnings
can reduce the present value
of a company’s tax burden.
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Reasons to Manage Risk (cont’d)
7. Compensation systems
The manager’s bonus is higher if earnings are
stable. Even if hedging does not add much
value for stockholders, it may still benefit
managers.
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Background to Derivatives
• Derivative: Security whose value stems or is
derived from the value of other assets (socalled underlying assets). Swaps, options, and
futures are examples of derivatives used to
manage financial
risk exposure.
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Natural Hedges
• Natural hedges, defined as situations in which
aggregate risk can be reduced by derivatives
transactions between two parties
• Natural hedges occur when futures are traded
between cotton farmers and cotton mills, copper
mines and copper fabricators, electric utilities
and coal mines. In all such situations, hedging
reduces aggregate risk and thus benefits the
economy.
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The Rapid Growth of Derivatives
Markets
• Analytical techniques have been developed to
help establish “fair” prices.
• Computers and electronic communications
make it much easier for counterparties to deal
with one another.
• Globalization has greatly increased the
importance of currency markets and the need
for reducing the exchange rate risks brought
on by global trade.
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The Downside of Derivatives
• Being very important tools for corporate risk
management, derivatives also have a potential
downside.
• Due to the high leverage, very small
miscalculations can lead to huge losses, especially
when misunderstood and misused.
• The horror stories such as those at LTCM point
out the need for top managers to exercise control
over the personnel who deal with derivatives.
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Other Types of Derivatives
•
•
•
•
Forward/Futures contracts
Swaps
Structured notes
Inverse floaters
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Forward Contracts
• A forward contract specifies that one party agrees to
buy a certain commodity at a specific price on a
specific future date and the other party agrees to sell
the product.
– It is an obligation, NOT an option: Both parties are
required to hold up till the end.
• There is a danger that one party will default on the
contract, especially if the commodity price changes
markedly after the agreement is reached.
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Futures Contracts
• A futures contract is like a forward contract:
– It specifies that a certain commodity will be
exchanged for money at a specific time in the future
at prices agreed today.
• A futures contracts is different from a forward:
– Futures are standardized contracts trading on
exchanges with daily resettlement (“marking-tomarket”) and with almost no physical delivery of the
underlying commodity.
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Forward vs. Futures
Forward
Futures
Contracts
Customized
Standardized
Trading
Dealer or OTC
Exchanges
Default Risk
High
No
Initial Deposit
N/A
Margin Account
Settlement
On maturity
Marking-to-Market
Delivery
Often
Seldom
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Swaps
• A swap is just what the name implies – two
parties agree to swap something, generally
obligations to make specified payment
streams.
• There are variations on swaps involving fixedto-fixed, fixed-to-floating, and floating-tofloating with same or different currency.
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Interest Rate Swap:
A Numerical Example
• Reduce borrowing costs by using interest rate
swaps.
• Example: Two firms with different credit
ratings, Hi and Lo:
– Hi can borrow fixed at 10% or floating at LIBOR +
1%
– Lo can borrow fixed at 10.4% or floating at LIBOR
+ 1.5%
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Interest Rate Swap:
A Numerical Example (cont’d)
Fixed Rate
Floating Rate
Company Hi
10.0%
LIBOR + 1.0%
Company Lo
10.4%
LIBOR + 1.5%
Hi wants fixed rate, but it will issue floating
and “swap” with Lo. Lo wants floating rate,
but it will issue fixed and swap with Hi.
In this swap, Hi pays 8.95% fixed and Lo
pays LIBOR floating rate.
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Interest Rate Swap:
A Numerical Example (cont’d)
Hi
CF to lender
Lo
-(LIBOR+1%)
-10.40%
CF Hi to Lo
-8.95%
+8.95%
CF Lo to Hi
+(LIBOR%)
-(LIBOR%)
-9.95%
-(LIBOR+1.45%)
Net CF
The rate paid is 9.95% versus 10% that Hi
needs to pay for issuing fixed-rate debt
directly. Lo also saves 0.05% through the
agreement. The swap leaves both better off.
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Interest Rate Swap:
A Numerical Example (cont’d)
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Structured Notes
• Structured note often means a debt obligation
that is derived from some other debt
obligation.
• Zeros formed by stripping GOC-bonds were
one of the first types of structured notes.
• Structured notes permit a partitioning of risks
to give investors what they want.
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Inverse Floaters
• A floating-rate note has an interest rate that
rises and falls with some interest rate index.
• The market value of the note would be
relatively stable.
• With inverse floaters, the rate paid on the note
moves counter to market rates.
• Inverse floaters can be effectively used for
hedging purposes.
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Corporate Risk Management
• Corporate risk management is the
management of unpredictable events
that would have adverse consequences for the
firm.
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Process for Managing Risks
Three steps of corporate risk management
• Step 1: Identify the risks faced by the firm.
• Step 2: Measure the potential impact of the
identified risks.
• Step 3: Decide how each relevant risk should
be dealt with.
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Different Types of Risk
• Pure risks: Those that offer only the prospect
of a loss (e.g., product liability)
• Speculative risks: Those that offer the chance
of a gain as well as a loss
• Demand risks: Those associated with the
demand for a firm’s products or services
• Input risks: Those associated with a firm’s
input (labour and materials) costs
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Different Types of Risk (cont’d)
• Financial risks: Those that result from financial transactions
(e.g., interest rate risk with financing)
• Property risks: Those associated with loss of a firm’s
productive assets
• Personnel risk: Risks that result from human actions (e.g.,
employee fraud or embezzlement)
• Environmental risk: Risk associated with polluting the
environment
• Liability risks: Connected with product, service, or
employee liability
• Insurable risks: Those that typically can be covered by
insurance (e.g., property and liability risks)
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Risk-Reducing Actions
• What actions can companies take to
minimize/reduce risk exposures?
– Transfer risk to an insurance company by paying
periodic premiums
– Transfer the function that produces risk to third
parties (outsource)
– Purchase derivatives contracts to reduce input
and financial risks
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Risk-Reducing Actions (cont’d)
• Take actions to reduce the probability of
occurrence of adverse events (e.g., the
probability of a fire).
• Take actions to reduce the magnitude of the
loss associated with adverse events (e.g.,
installing sprinkler systems).
• Avoid the activities that give rise to risk (e.g.,
discontinue a product or service).
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Financial Risk Management Concepts
• Financial risk exposure refers to the risk
inherent in the financial markets due to price,
interest rate, and exchange rate fluctuations.
• Example: A firm holds a portfolio of bonds,
interest rates rise, and the value of the bonds
falls.
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Using Derivatives to Reduce Risks
• For an investor, one of the most obvious ways
to reduce financial risks is to hold a broadly
diversified portfolio of stocks and debt
securities.
• However, derivatives can also be used to
reduce the risks associated with financial and
commodity markets.
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Hedging With Futures
• Futures: Contracts that call for the purchase or
sale of a financial (or real) asset at some
future date, but at a price determined today.
Futures (and other derivatives) can be used
either as highly leveraged speculations or to
hedge and thus reduce risk.
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Hedging With Futures (cont’d)
The basic contract is for $100,000 of a hypothetical 6% Government of Canada
bond with 10 years to maturity. GCB bond futures data below:
Futures Price ( GCB Contract, $100,000 Government of Canada Bonds)
Delivery Last
Change High
Low
Volume
Open
Month
Price
Interest
June2012 131.18 -0.04
119.25
118.49
32,430
229,401
Source: The Montreal Exchange, http://www.m-x.ca, March 28, 2012
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Hedging With Futures (cont’d)
Using a financial calculator, input
N = 20, PV = -1311.8, PMT = 30, FV = 1,000
I/Y = 1.2316
Equivalent to a nominal annual rate of 2.4632%
N = 20, PV = -1312.2, PMT = 30, FV = 1,000
I/Y = 1.2297
Equivalent to a nominal annual rate of 2.4593%
Interest rates rose by only about 4/10 of a basis point from the
previous day, but that was enough to decrease the value of the
contract by $40 (= $131,180 – $131,220).
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Hedging With Futures (cont’d)
When futures contracts are purchased, the purchaser is
required to post an initial margin, which for CGB bond
contracts is $2,000 per $100,000 contract. If an
investor purchased and sold it later for $135,000, he or
she would have made a profit of $135,000 – $131,180
= $3,820
on a $2,000 investment, or a return of 91% in
only 3 months.
If interest rates had risen, then the value of the
contract would have fallen, and the investor could
easily have lost his or her $2,000 or more.
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Speculation vs. Hedging
• Speculation involves betting on future price
movements, and futures are used because of
the leverage inherent in the contract.
• Hedging is done by a firm or individual to
protect against a price change that would
otherwise negatively affect profits.
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Two Basic Types of Hedges
– Long hedge: Involves the purchase of a futures
contract to guard against a price increase
– Short hedge: Involves the sale of a futures
contract to protect against a price decline in
commodities or financial securities
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T-Bond Futures Contract
• It is January, and Toronto Sunshine will issue
$10,000,000 of 10-year bonds in June. TS is
worried interest rates will rise between now
and then.
• The interest rate would be 9% paid
semiannually if the bonds were issued today.
But TS fears rates might rise by 1% by June.
• June CGB bond future is 131.18%.
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T-Bond Futures Contract (cont’d)
In this situation, TS would be hurt by an
increase in interest rates, so it would use a
short hedge.
TS would choose a futures contract on the
security most similar to the one it plans to
issue, long-term bonds, and so would
probably hedge with June CGB bond futures
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T-Bond Futures Contract (cont’d)
• Each T-bond futures is sold at a price of
1.3118($100,000) = $131,180.
• Sell $10,000,000/$131,180 = 76 contracts to
hedge a portfolio of $10,000,000.
• Need 76*$2,000=$152,000 in margin money
and also to pay commissions.
• Total contract value = 76*$131,180 =
$9,969,680, which is close enough to cover
the risk exposure.
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T-Bond Futures Contract (cont’d)
• However, the increase in interest rates would also bring about a change
in the value of TS’s short position in the futures market.
• Since interest rates have increased, the value of the futures contract
would fall. If the interest rate increased from 9% to 10%:
N = 20, I/Y= 10/2 = 5, PMT = -450,000, FV = -10,000,000,
PV =
9,376,889
• TS would have received $10,000,000 – $9,376,889 = $623,111 less from
bond issuance by delaying the financing.
• However, if the interest rate on the futures contract also increased by
the same full percentage point, from 2.46% to 3.46%, the new contract
value would be $121,318.
• Total value of this position = 76*$121,318 = $9,220,168.
• Profit = $9,969,680 – $9,220,168 = $749,512 less commissions
• TS uses the profit from futures to offset the loss on the bond issue;
actually, more than offset $749,512 – $623,111 = $126,401
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Futures Price Changes
• T-bond futures prices change every day as
interest rates change. If interest rates
increase, the bond prices decrease and so
does the T-bond futures price. If interest rates
decrease, then bond prices increase, and so
does the T-bond futures price.
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Hedging With Swaps
• Standardized contracts have been developed
for many types of swaps, lowering the time
and effort involved in arranging swaps and
thus transaction costs and increasing liquidity.
• Now many international banks take
counterparty positions in swaps, making swap
market more efficient.
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Hedging With Swaps: An Example
• An electric utility issued a 5-year floating-rate note tied
to the prime rate.
• Concerned about possible rise in the prime rate, it
could enter into a swap with Royal Bank.
• In the swap, the utility would pay a fixed rate to Royal
Bank in order to receive the floating-rate from the
Bank.
• As a result, the utility converts its floating-rate debt
into a fixed-rate one.
• As banks’ revenues rise as interest rates rise, Royal
Bank’s risk would actually be lower with floating-rate
obligations.
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Commodity Futures Markets
• How can commodity futures be used to
reduce input price risk?
• The purchase of a commodity futures contract
will allow a firm to make a future purchase of
the input at today’s price, even if the market
price on the item has risen substantially in the
interim.
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Use and Misuse of Derivatives
• Hedging is cited as a “good” use of derivatives,
whereas speculating with derivatives is
considered to be “bad.” In fact, derivatives are
neutral themselves.
• The leverage inherent in derivatives contracts
make them potentially dangerous.
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Use and Misuse of Derivatives (cont’d)
• Derivatives can and should be used to hedge
against certain risks.
• CFOs, CEOs, and board members should be
reasonably knowledgeable about derivatives
their firms use, should establish policies
governing their use, and should establish audit
procedures to ensure that the policies are
carried out.
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