CHAPTER 25
DERIVATIVES AND HEDGING RISK
SLIDES
22.1 Key Concepts and Skills
22.2 Chapter Outline
22.3 Forward Contracts
22.4 Futures Contracts
22.5 Futures Contracts
22.6 Daily Resettlement: An Example
22.7 Daily Resettlement: An Example
22.8 Daily Resettlement: An Example
22.9 Daily Resettlement: An Example
22.10 Selected Futures Contracts
22.11 Futures Markets
22.12 Wall Street Journal Futures Price Quotes
22.13 Basic Futures Relationships
22.14 Hedging
22.15 Hedging and Speculating: Example
22.16 Hedging: How many contracts?
22.17 Interest Rate Futures Contracts
22.18 Pricing of Treasury Bonds
22.19 Pricing of Treasury Bonds
22.20 Pricing of Forward Contracts
22.21 Pricing of Forward Contracts: Example
22.22 Pricing of Forward Contracts: Example
22.23 Pricing of Futures Contracts
22.24 Hedging in Interest Rate Futures
22.25 Duration Hedging
22.26 Duration Hedging
22.27 Duration Formula
22.28 Calculating Duration: Example
22.29 Calculating Duration: Example
22.30 Duration
22.31 Swaps Contracts
22.32 The Swap Bank
22.33 An Example of an Interest Rate Swap
22.34 An Example of an Interest Rate Swap
22.35 An Example of an Interest Rate Swap
22.36 An Example of an Interest Rate Swap
22.37 An Example of an Interest Rate Swap
22.38 An Example of an Interest Rate Swap
22.39 An Example of an Interest Rate Swap
25.40 An Example of an Interest Rate Swap
CHAPTER ORGANIZATION
22.1 Derivatives, Hedging, and Risk
22.2 Forward Contracts
22.3 Futures Contracts
22.4 Hedging
22.5 Interest Rate Futures Contracts
Pricing of Treasury Bonds
Pricing of Forward Contracts
Futures Contracts
Hedging in Interest Rate Futures
22.6 Duration Hedging
The Case of Zero Coupon Bonds
The Case of Two Bonds with the Same Maturity but with Different Coupons
Duration
Matching Liabilities with Assets
22.7 Swaps Contracts
Interest Rate Swaps
Currency Swaps
Credit Default Swaps
Exotics
22.8 Actual Use of Derivatives
22.40 An Example of an Interest Rate Swap
22.41 An Example of a Currency Swap
22.42 An Example of a Currency Swap
22.43 An Example of a Currency Swap
22.44 An Example of a Currency Swap
22.45 An Example of a Currency Swap
22.46 An Example of a Currency Swap
22.47 An Example of a Currency Swap
22.48 Credit Default Swaps
22.49 Variations of Basic Swaps
22.50 Risks of Interest Rate and Currency Swaps
22.51 Risks of Interest Rate and Currency Swaps
22.52 Pricing a Swap
22.53 Actual Use of Derivatives
22.54 Quick Quiz
ANNOTATED CHAPTER OUTLINE
Slide 25.0 Chapter 25 Title Slide
Slide 25.1 Key Concepts and Skills
Slide 25.2 Chapter Outline
1. Derivatives, Hedging, and Risk
The value of a derivative asset is “derived” from an underlying primary
asset. Derivatives can be used to change an individual’s or firm’s risk
exposure.
2. Forward Contracts
Slide 25.3 Forward Contracts
Forward contract – agreement between a buyer (long) and a seller (short)
for future delivery of an asset at a price specified today
Forward price – price agreed upon today to be paid at a future date when
delivery occurs
Settlement date – date when delivery occurs and the forward price is paid
(received)
Lecture Tip: In a forward contract, both parties are legally bound to
execute the transaction in the future at the agreed-upon price, but no
money changes hands at the inception of the contract. Here is an example
to help explain this concept to students.
Suppose you want to buy a new Ford Mustang convertible as soon as it
becomes available. You contract with the dealer to pay a specified price
on a specified future date (the delivery date). In essence, a private-market
forward contract has been created. You have a long position (buyer) in the
underlying asset (Mustang) and the Ford dealer has a short position
(seller).
Now suppose that after the contract is signed, demand for the car rises
so that the market value of the car increases above the agreed-upon price.
You have a document that gives you the
right to buy the asset at below market prices, and the dealer is obligated
to sell at that price. The “long” position wins because prices have
increased.
Suppose on the other hand, the economy worsens and the demand for
cars decreases. This drives the market value of the car lower. The dealer,
however, has a contract that forces you to pay the above market price. In
this case, the “short” position wins because prices have decreased.
What keeps either party from defaulting on the contract? This question
is a good lead-in to the discussion of futures, margin and marking-to-
market.
3. Futures Contracts
Slide 25.4 –
Slide 25.5 Futures Contracts
Futures contract – standardized forward contract traded only on an
exchange with gains and losses recognized on a daily basis
Slide 25.6 –
Slide 25.9 Daily Resettlement: An Example
Marking-to-market – process for daily recognizing gains and losses
Slide 25.10 Selected Futures Contracts
Typically, futures contracts are divided into two broad categories
– commodity contracts such as oil, gold, or wheat
– financial contracts such as T-bond or S&P 500
Slide 25.11 Futures Markets
Lecture Tip: So what are the major differences between an OTC forward
contract and an exchange traded futures contract?
Forward Futures
Customized Standard features (delivery date, size of
contract, quality of asset, etc.)
Search cost – use dealers No search cost – contact broker
Low liquidity High liquidity
Higher default risk – limited to large,
creditworthy institutions
Virtually no default risk
No up-front or intermediate cash flows Initial margin requirements, daily marking-to-
market, margin calls
No Clearinghouse Clearinghouse that guarantees performance
Delivery normally occurs Majority of contracts offset, not delivered
Lecture Tip: How do we ensure that both parties fulfill their end of the
contract, particularly if there is a large price movement one way or the
other? The answer provides the main distinguishing characteristic
between straight forward contracts and futures contracts. The only
guarantees with a forward contract are the fear of litigation if one party
defaults and wanting to maintain a good reputation.
Suppose instead of entering into a forward contract with the dealer,
you enter into a futures contract with the Mustang as the underlying asset.
In this instance, both parties would deposit margin (or a good-faith
deposit) with an independent third party. Funds would then be transferred
back and forth between your account and the dealer’s account on a
regular basis as the price of the Mustang fluctuated. When it came time to
buy the car, any gain or loss would already be accounted for, thereby
reducing the likelihood of default.
Slide 25.12 Wall Street Journal Futures Price Quotes
Slide 25.13 Basic Futures Relationships
Settlement price – price at which contracts are marked-to-market and
determined by the settlement committee at each exchange, may or may not
equal the price at the last trade
Open interest – number of outstanding contracts
One problem with forward contracts is enforcing the agreement on the
delivery date. If the cash price on the delivery date is higher than the
agreed price, the seller has the incentive to default, and vice versa. Futures
contracts greatly reduce the risk of default relative to forward contracts by:
1. Having an exchange clearinghouse take one side of every
transaction.
2. Requiring an initial and a maintenance margin.
3. Marking to market on a daily basis.
4. Hedging
Slide 25.14 Hedging
Slide 25.15 Hedging and Speculating: Example
Slide 25.16 Hedging: How many contracts?
Hedging is the process of reducing risk, whether it be the risk of changing
prices, currency fluctuations, or changes in interest rates.
Speculating is the opposite of hedging, which implies it is the process of
increasing risk.
Both hedgers and speculators are necessary for an active, liquid
derivatives market.
While forward and futures contracts can be used for speculative purposes,
the chapter focuses on the use of these derivative securities to reduce risk.
Either side of a forward or futures contract can be used to hedge:
1. A short futures hedge involves selling a futures contract. Short hedges
are used when you will be making delivery of an asset at a future date
(e.g., a farmer anticipating a harvest of wheat) and wish to minimize the
risk of a drop in price.
2. A long futures hedge involves buying a futures contract. Long hedges are
used when you must purchase an asset at a future date (e.g., a bakery with
a demand for wheat) and wish to minimize the risk of a rise in price.
Lecture Tip: It may be beneficial to demonstrate a futures hedge and the
potential payoffs for a soybean farmer who anticipates a harvest of
100,000 bushels in September. Costs to produce the soybeans are incurred
long before the harvest, but the farmer is at risk that the price of soybeans
will fall before harvest time. To reduce this risk, the farmer takes a short
position (because he wants to sell the soybeans) in the futures contract.
This short position offsets the long position that he already has in
soybeans.
Futures contract terms are for 5,000 bushels, and the current futures
price is $4.50 per bushel. The farmer can lock in the delivery price of
soybeans at $4.50 for his harvest by shorting (selling) 20 soybean futures
contracts on June 1st. No cash changes hands today, although margin is
held in the farmer’s account. The 20 contracts represent delivery of
100,000 bushels. The cash flow at delivery is $4.50(100,000) = $450,000
Date Closing Farmer Net
06/01 no money changes hands
06/10 4.60 pay 10,000 (-.1*100,000) -10,000
06/15 4.40 receive 20,000 (.2*100,000) +10,000
06/30 4.20 receive 20,000 +30,000
07/20 4.30 pay 10,000 +20,000
08/05 4.40 pay 10,000 +10,000
08/16 4.20 receive 20,000 +30,000
09/01 4.20
The farmer will deliver the soybeans and receive $4.20 per bushel for
420,000 + 30,000 profit from the futures for a total cash inflow of
450,000.
If a bumper crop occurs and the farmer harvests 120,000 bushels, the
farmer will receive 450,000 for the first 100,000 and then an addition
20,000*4.20 = 84,000 for the extra.
Suppose instead there is a poor harvest and the farmer only has 70,000
bushels. But, because of the short supply, the price is $4.75 per bushel.
The farmer would realize a loss of 25,000 (.25*100,000) on the futures
contracts and would receive 70,000(4.75) = 332,500 for the sale of the
soybeans. His net profit would be $307,500. As this illustrates, the farmer
can only hedge price risk, not quantity risk.
5. Interest Rate Futures Contracts