Risk Transfer through Hedging

Erman Sumirat

MBA SBM ITB

 What is Derivatives?
• Synthetic Securities that derive their value
(price) from a related physical market
security
• For example: gold, listed shares, foreign
exchange, interest rate, bank bills and
government bonds
• Speculative or pure risk?
 Financial Derivatives
• Financial Derivatives are products
essentially designed to facilitate the
synthetic management of financial risk
(e.g. i/r risk; f/x risk; commodity price risk)
• Futures
• Forwards
• Options
• Swaps
• What is the difference among those?
 Derivatives
• Investor risk management
Change in firm value

Physical Market

Change in i/r

Risk Market
 Derivatives
• Investor risk management
Change in firm value
Risk Market

Change in i/r

Physical Market
 Futures

• A contractual agreement between two

parties to buy or to sell a stated quantity of
a specific item, on a specified date in the
future, at a predetermined price
 Futures Contract Hedge
• Electronic Trading

• Deposit and Margin are required

• Trades guaranteed by the clearing house

• Standardized Contract
 Futures Contract
90-Day Bank Bills
• Contract Face Value $1 Million
• Price = Yield to two decimal places
• Quoted as an index of 100 minus yield
(i.e.) yield 5.63 % quoted as 94.37
- Formula
- Price = $ 1,000,000 * 365
365 + (Yield/100*90)
 Futures Contract
90-Day Bank Bills
• Example: a company Physical Futures
has to borrow in three
months and is
concerned that Today 10% Sell 88
interest rates may rise
Buy 86
before it obtains the
loan: 3M 14%

- 2 % Profit 2%
Net Cost 12%
 Futures Example (1) –
Buying Hedge
• A funds manager is to reinvest $2 Million in 3
months. Current investment rates are 12.6% p.a.
but the manager is concerned that the rates are
going to fall prior to the reinvestment date
• The manager decides to hedge the position
using 90 days bills futures contract
• The steps are: December is buying two march
contract at 88.11and sell two march contract at
89.49 (Action Now)
• On march will invest in commercial paper at
current market rates of 10.5 % (Future Action)
 Physical (Cash) Market Derivatives (Futures) Market

December
Expect to reinvest $2 Million in Buy 2 march Contracts at 11.89%
3 months – current market Value $ 1,943,034.49
rates 12.6% Pay Deposit; Meet future margin
calls
March
Invest in CP at 10.5% Prior to expiry date sell 2 march
Cost $ 1,949,525.97 contracts at 10.51 %
Interest 50,474.03 Value $ 1,949,479.12
Profit 6,444.63 Profit = $ 6,444.63
Total Return $ 56,918.66
Effective Yield = $ 56,918.66 * 365 * 100 = 11.88 %
$ 1,943,081.34 * 90 * 1
 Futures Example (2) –
Selling Hedge
• A company has an existing bank bill loan facility
of $ 1 Million which it will roll-over in 3 months.
The company is concerned that interest may rise
and decides to hedge its exposure using 90 day
bank accepted bills futures contract
• On March, current rates is 11.50 %
• The steps are: March is selling one June
contract at 88.12 and Buy one June contract at
87.00 (Action Now)
• On June will roll over loan at current market
rates of 12.95 % (Future Action)
 Physical (Cash) Market Derivatives (Futures) Market

March
Roll over $ 1 Million loan in 3 Sell one June contract at 11.88 %
months time – current rates - Value $ 971,540.52
are 11.50 % Pay deposit; meet future margin
calls
June
Roll Over bank bills Prior to expiry date buy one
@12.95% June contract at 13.00 %
Cost $ 969,056.56 Value $ 968,940.80
Interest 30,943.44 Profit = $ 2,599.72
Profit 2,599.72
Net Cost $ 28,343.72
Effective Yield = $ 28,343.72 * 365 * 100 = 11.83 %
$ 971,656.28 * 90 * 1
 Forward Rate Agreement
• An agreement between a borrower or an
investor and a FRA Dealer on an interest rate
level that will apply at a specified future date
• No underlying transaction necessary
• The FRA relates to future interest rates, there is
no exchange of principal
• Settlement is the value of the difference between
the FRA agreed rate and current rates on the
future settlement date
 Forward Rate Agreement
• Contract Prices are quoted as two way
Buy Sell
• 2Mv5M 10.50 % 10.00 %
• 3Mv6M 11.20 % 10.70 %
• 3Mv9M 12.00 % 11.75 %

• Buy Rate : rate at which dealer will lend

• Sell Rate : rate at which dealer will borrow
 FRA Calculation –
Discounted Security
• FRA Settlement Price – FRA Contract
Price

• 365 * P - 365 * P
365 + (is * d) 365 + (ic * d)
Settlement Rate Contract Rate

Note: I is expressed as a decimal

 FRA Calculation –
Discounted Security
• Example: A company wishes to lock in the
i/r on a six month $ 500,000 loan which
will roll-over in two months time. FRA rates
are quoted as:
• 2Mv6M 8.25 8.10
• 2M v 8 M 8.30 8.15
At the contract start date the reference rate
(BBSW) is 8.75 %
 FRA Calculation –
Discounted Security

• 365 * P - 365 * P
365 + (is * d) 365 + (ic * d)
Settlement Rate Contract Rate
365* 500,000 - 365 * 500,000
365 + (0.0875*182) 365 + (0.0830 *182)
= $ 479,096.94 - 480,129.23 = ($1,032.29)

Compensation paid by the dealer to the customer

FRA Calculation

Change in firm value

FRA-
Risk Market
$1,032.29 Compensation
paid by dealer

8.30 % 8.75 % Change in i/r

Loan
Physical Market
 Settlement Rules

• Client Compensates FRA Provider when

rates move in client’s favour

• FRA Provider Compensates the client

should rates move against the client
 SWAPS
• Two parties contract to swap their
respective interest payment flows, based
on a notional principal payment amount,
over a predetermined period
- Changing the characteristic of existing
cash flows (e.g. exchanging fixed i/r
payments based on a notional principal
amount for variable i/r payments)
 SWAPS
• An exchange of interest receipts is an asset
swap
• An exchange of interest obligations is a liability
swap
• Need to know:
- calculation basis (360 or 365 days)
- Reference rate (LIBOR; BBSW)
- Counterparty risk
Based on the comparative advantage
SWAPS – Comparative Advantage

Debt ABC Ltd XYZ Ltd

Markets
Fixed i/r 12.00 % 14.00 %
Floating i/r Libor + 0.5 % Libor + 1.7 %
 SWAPS – Comparative Advantage
Debt ABC Ltd XYZ Ltd Difference
Markets
Fixed i/r 12.00 % 14.00 % 2.00 %
Floating i/r Libor + 0.5 % Libor + 1.7 % 1.20 %
Net Differential 0.80 %

ABC Ltd has a credit advantage in both markets but

Has a comparative advantage in the fixed i/r market.
The net difference of 0.8 % represents the potential
Gains to be made through a swap between 2 parties
 Construction of SWAP
• ABC Ltd issues debentures with a fixed
interest rate (12%)
• XYZ Ltd obtains a bank loan at floating
interest rate (LIBOR + 1.70%)
• Both companies separately ask Bank
Mega to engineer a swap facility (fee:
0.10%)
 Construction of SWAP

Mega Bank
ABC Ltd XYZ Ltd
Fee 0.10 %

Fixed Rate Floating Rate

12 % Libor + 1.7 %
Debentures Bank Loan
 Construction of SWAP
LIBOR
Mega Bank
ABC Ltd
Fee 0.10 %
12 %

12 %

Fixed Rate
12 %
Debentures
Construction of SWAP
Libor + 1.7 %
Mega Bank
XYZ Ltd
Fee 0.10 %
13.80 %

Libor + 1.7 %

Floating Rate
Libor + 1.7 %
Bank Loan
 Construction of SWAP
LIBOR LIBOR + 1.7 %
Mega Bank
ABC Ltd XYZ Ltd
Fee 0.10 %
12 % 13.80 %
12 % Libor + 1.7 %

Fixed Rate Floating Rate

12 % Libor + 1.7 %
Debentures Bank Loan
 Construction of SWAP
Net Cash Flows
ABC Ltd XYZ Ltd Bank
(12 %) (Libor + 1.70 %) (12 %)
(Libor) (13.80%) (LIBOR + 1.7 %)
12 % Libor + 1.70 % 13.80 %
LIBOR
LIBOR 13.80 % 0.10 %

0.5 0.2 0.10

 SWAPS – Role of Banks
• Run an active trading book
• Find matching counterpart
• Provide confidentiality to counterparty
• Absorb credit risk
• Provide flexibility to meet customer needs
• Provide liquidity to the market
• Source of fee income
 Options
• An Option is the right but not an obligation
to buy or sell a commodity at a specified
future date and at a predetermined price
• Allows the hedging of the down side of
interest rate, exchange rate or commodity
price movements but also allows
advantage of any up-side movements to
be gained
 Options
• Call Options – give the option buyer the right to
buy the commodity at the exercise price
- Buyer benefits if commodity price is above the
exercise price; Spot > Exercise Price
• Put Options – give the option buyer the right to
sell the commodity at the exercise price
- Buyer benefit if commodity price is below the
exercise price; Spot < Exercise Price
 Options
• Premium – Paid to the writer of an option
contract
• Exercise Price (Strike Price) – Agreed Value at
which the option may be exercised
• European Option – Exercised only on expiry
date
• American Option – Exercised at any time up to
expiry date; more expensive
• Exporters and Importers use which option?
 Options
• Exchange Traded Options standardized options
listed and traded on a formal exchange (e.g.
CME, SFE and ASX)
• Over the counter options – Customized options
offered by financial institutions
- CAPS: Upper limit on an interest rate
- FLOORS: Lower limit on an i/r
- COLLARS: Strategy combining both a cap and
a floor (thus reducing cost of option)
 Options
• “ in the money” (ITM)

- Call: Stock Price > Exercise Price

- Put : Exercise Price > Stock Price

• “Out of the money” (OTM)

- Call : Stock Price < Exercise Price

- Put : Exercise Price < Stock Price
 Options - Example
• You forecast WMC Shares will rise and decide
to hedge by buying a 3 month call option at
$12.00. Premium of $1.50 is paid
• If WMC shares are trading at $ 15.00 at the
exercise date, Will the option be exercised?
• If WMC shares are trading at $ 11.00 at the
exercise date, Will the option be exercised?
• If WMC shares are trading at $ 13.00 at the
exercise date, Will the option be exercised?
 Call Option – Profit and Loss
Profile
Buyer (Long Call) Writer (Short Call)
Profit
$ 1.50

$ 12.00 $ 13.50 $ 12.00 $ 13.50

Market
Price
$ 1.50
BEP BEP
Loss Exercise Loss Exercise
Price Price
 Factors Affecting Option Premium
• Price Spread
- Between current market price (i/r) and option
exercise price
• Market Expectations
- Volatility and Uncertainty
• Intrinsic and Time Value
- Payments due (e.g. dividends)
- Period to maturity
 Options - Advantages
• Limits down-side, but upside open
• Useful in a volatile interest rate market
• No need for underlying transaction
• Insurance-premium paid
• Can be sold if option is in the money
• Alternative to other derivative products –
Nonlinearity
 Creating a Synthetic Forward
• Collar
• Sell a call option – Receive premium
• Buy a put option – Pay premium
• Both with the same maturity
• Spot Rate will mean one will be in the
money the other will be out of the money
• Limits your gain and limits your loss so is
in effect the same as futures or forward
 Creating a synthetic forward
• Example you are exposed to DM:
• Sell a call option – Receive Premium - .62
• Buy a put option – Pay Premium - .60
• If the rate goes up to .57 Put has an
intrinsic value, call would expire
• If the rate goes up to .65 call have intrinsic
value, put would expire