analysis of securities

1. Chapter 24
Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Risk Management

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Topics Covered
Why Hedge?
Reducing Risk with Options
Futures Contracts
Forward Contracts
Swaps
Innovation in the Derivatives Market
Is “Derivative” a Four-Letter Word?

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Why Hedge?
Question of The Day
What is a cereal company in the business of
doing?
A. Producing a product efficiently and selling it for
a profit.
B. Speculating on the price of sugar, wheat, and other
inputs to its product.
Answer: Both

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Why Hedge?
Question of The Day
The company does A. by choice and B. because
it has no choice.
The company can eliminate B through
Hedging

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Reducing Risk With Options
Example - Onnex sells crude oil. Since its costs are
relatively fixed, fluctuations in the sale price of
crude oil can cause unexpected profits or losses.
How might Onnex hedge this risk?

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Reducing Risk With Options
Example - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause
unexpected profits or losses.
How might Onnex hedge this risk?
Price per barrel
Onnex’s loses
money when
prices drop.
Revenues

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Reducing Risk With Options
Example - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause
unexpected profits or losses.
How might Onnex hedge this risk?
Price per barrel
A put option
makes money
when prices drop.
Revenues

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Reducing Risk With Options
Example - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause
unexpected profits or losses.
How might Onnex hedge this risk?
Price per barrel
Onnex’s natural
risk, plus a put
option provides a
HEDGE against
price declines.
Revenues

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Futures Contracts
Futures Contract - Exchange traded forward contract
with gains or losses realized daily.
Profit to seller
= initial futures price - ultimate market price
Profit to buyer
= ultimate market price - initial futures price

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Future Contracts
Example - The Farmer’s Hedge - A farmer owns
wheat in her fields and wishes to hedge against a
drop in the price she will potentially sell it for in
the open market.
Show the positions involved in this hedge.

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Future Contracts
The farmer loses
money when the
price drops
Price per bushel
Value
of
wheat
Example - The Farmer’s Hedge - A farmer owns wheat in
her fields and wishes to hedge against a drop in the price
she will potentially sell it for in the open market.
Show the positions involved in this hedge.

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Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in
her fields and wishes to hedge against a drop in the price
she will potentially sell it for in the open market.
Show the positions involved in this hedge.
The futures
contract profits
when prices drop
Price per bushel
Value
of
wheat

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Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in
her fields and wishes to hedge against a drop in the price
she will potentially sell it for in the open market.
Show the positions involved in this hedge.
With a futures
contract the
farmer locks in a
price
Price per bushel
Value
of
wheat

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Financial Futures
Goal (Hedge) - To create an exactly opposite
reaction in price changes, from your cash position.
Commodities - Simple because assets types are
finite.
Financials - Difficult because assets types are
infinite.
You must attempt to approximate your position
with futures via “Hedge Ratios.”

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Financial Futures
Eurex
Bond
Govt.
German
IMM
Yen
IMM
Euro
IMM
Index
s
Poor'
and
Standard
IMM
deposits
Eurodollar
CBT
bonds
Treasury
U.S.
CBT
notes
Treasury
U.S.
Exchange
Future

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Forward Contracts
Forward Contract - Agreement to buy or sell
an asset in the future at an agreed price.
Forward contracts are “custom designed”
futures contracts. They have specific
amounts and expiration dates to meet the
buyers’ needs.

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Swaps
Swap - Arrangement by two counterparties to
exchange one stream of cash flows for another.
Company Swap Dealer
Fixed rate pmt
LIBOR pmt
LIBOR pmt

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Example - Interest Rate Swaps
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan7.25% 7.50%
Swap
Aaa Corp Borrows $1mil fixed loan @ 10%
BAA Corp Borrows $1mil variable loan @ 7.5%
Aaa assumes pmts on variable loan @ 7.5%
Baa assumes pmts on fixed loan @ 10.75%

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Aaa Benefit
Pay Fix @ -10.00%
Get Fix @ +10.75%
Pay Var @ - 7.50%
Var Sav @ + 7.25%
Net Benefit + .50%
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan7.25% 7.50%
Example - Interest Rate Swaps

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Aaa Benefit Baa Benefit
Pay Fix @ -10.00% Pay Var @ - 7.50%
Get Fix @ +10.75% Get Var @ + 7.50%
Pay Var @ - 7.50% Pay Fix @ -10.75%
Var Sav @ + 7.25% Fix Sav @ +11.50%
Net Benefit + .50% Net Benefit + .75%
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan7.25% 7.50%
Example - Interest Rate Swaps

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Currency Swaps
Similar to interest rate swaps
Same type loan, just diff currency WHY?
example:
you have an investment in Japan
Project is financed with US bonds
You look for SWAP partner so you can emulate holding
Japanese bonds
Java Yahoo principal
Yen loan 11% 12% $ 1 mil
$ loan 8% 11.1% or Y120

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Currency Swaps
example - cont
Java borrows $1mil @ 8%
Yahoo borrows Y120mil @ 12%
Intl. Bank arranges swap
Java swaps 8% $ loan for 10.3% yen loan w/bank
Yahoo swaps 12% yen loan for 10.4% $ loan w/bank
total available benefit = (11.1-8) - (12-11) = 2.1%

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Currency Swaps
example - cont
benefit to Java
$ loan +8 - 8 = 0
Yen loan +11 - 10.3 = .7 net gain +.7%
benefit to Yahoo
$ loan 11.1 - 10.4 = +.7
yen loan -12 + 12 = 0 net gain = .7%
benefit to bank
$ loan +10.4 - 8 = +2.4
yen loan - 12 + 10.3 = -1.7 net gain + .7%

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Derivative Innovations
The creative mind is the only barrier to new
derivative products. Even Weather
Derivatives have come into existence in
recent years.
Example: A TV network may
want to hedge the risk of a
World Series game being
rained out and thus they
forego advertising income.
Who might the counterparty
be to such a contract?