Chapter Outline

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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

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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.
• Its 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.

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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.

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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.

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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).

Currently US1 140.
The 3-month forward price is US1150.
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Daily Resettlement An Example

• Currently US1 140 and it appears that the
  dollar is strengthening.
• If you enter into a three-month futures contract
  to sell at the rate of US1 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

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Daily Resettlement An Example

• If tomorrow, the futures rate closes at US1
  149, then your positions value drops.
• Your original agreement was to sell 12,500,000
  and receive US83,333.33

But 12,500,000 is now worth US83,892.62
You have lost US559.28 overnight.
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Daily Resettlement An Example

• The US559.28 comes out of your US3,333.33
  margin account, leaving US2,774.05
• This is short of the US3,355.70 required for a
  new position.

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.
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Selected Futures Contracts
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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

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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 930 a.m. to 115 p.m. CT.

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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 720 a.m. to 200 p.m. CST.

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CME After Hours

• Extended-hours trading on GLOBEX runs from 230
  p.m. to 400 p.m dinner break and then back at it
  from 600 p.m. to 600 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.

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National Post Futures Price Quotes
Highest and lowest prices over the lifetime of
the contract.
Highest price that day
Closing price
Opening price
Daily Change
Lowest price that day
Number of open contracts
Expiry month
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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.

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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

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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 US0.70 per pound or
  US17,500 per contract.
• If futures prices rise by 5 cents, you will gain
• Gain 25,000 .05 10 US12,500
• If prices decrease by 5 cents, your loss is
• Loss 25,000 -.05 10 -US12,500

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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
  US2.05.
• To hedge you will sell 10 corn futures contracts

Now you can quit worrying about the price of corn
and get back to worrying about the weather.
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25.4 Interest Rate Futures Contracts

• Pricing of Treasury Bonds
• Pricing of Forward Contracts
• Futures Contracts
• Hedging in Interest Rate Futures

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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

Value of the bond under a flat term structure
PV of face value PV of coupon payments
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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

PV of face value PV of coupon payments
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Pricing of Forward Contracts

• An N-period forward contract on that Government
  of Canada Bond

Can be valued as the present value of the forward
price.
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Futures Contracts

• The pricing equation given above will be a good
  approximation.
• The only real difference is the daily
  resettlement.

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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.
• Its likely to be easier and cheaper to use
  interest rate futures contracts however.

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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.

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25.5 Duration Hedging

• Duration measures the combined effect of
  maturity, coupon rate, and YTM on bonds price
  sensitivity
• Measure of the bonds effective maturity
• Measure of the average life of the security
• Weighted average maturity of the bonds cash flows

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Duration Formula
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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.
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Calculating Duration
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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

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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.

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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.

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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 US10,000,000 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.

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An Example of an Interest Rate Swap

• Firm B is a BBB-rated U.S. company. It needs
  US10,000,000 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.

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An Example of an Interest Rate Swap

• The borrowing opportunities of the two firms are

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An Example of an Interest Rate Swap
The swap bank makes this offer to Bank A You pay
LIBOR 0.125 per year on US10 million for five
years and we will pay you 10.375 on US10
million for five years
Swap Bank
Bank A
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An Example of an Interest Rate Swap
0.5 of US10,000,000 US50,000. Thats quite a
cost savings per year for five years.
Heres whats in it for Bank A They can borrow
externally at 10 fixed and have a net borrowing
position of -10.375 10 (LIBOR 0.125)
LIBOR 0.5 which is 0.5 better than they can
borrow floating without a swap.
Swap Bank
Bank A
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An Example of an Interest Rate Swap
The swap bank makes this offer to company B You
pay us 10.5 per year on US10 million for five
years and we will pay you LIBOR 0.25 per year
on US10 million for five years.
Swap Bank
Company B
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An Example of an Interest Rate Swap
Heres whats in it for B
0.5 of US10,000,000 US50,000 thats quite a
cost savings per year for five years.
Swap Bank
They can borrow externally at LIBOR 0.5 and
have a net borrowing position of 10.5 (LIBOR
0.5 ) - (LIBOR 0.25 ) 11.25 which is 0.5
better than they can borrow floating.
Company B
LIBOR 0.5
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An Example of an Interest Rate Swap
The swap bank makes money too.
0.25 of US10 million US25,000 per year for
five years.
Swap Bank
Company B
Bank A
LIBOR 0.125 LIBOR 0.25 0.125 10.5
10.375 0.125 0.250
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An Example of an Interest Rate Swap
The swap bank makes 0.25
Swap Bank
Company B
Bank A
B saves 0.5
A saves 0.5
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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.

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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(/) US1.60/,
  the U.S. firm needs to find a British firm
  wanting to finance dollar borrowing in the amount
  of US16,000,000.

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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
  others country of the same size. Their borrowing
  opportunities are given in the table below.

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An Example of a Currency Swap
Swap Bank
Firm B
Firm A
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An Example of a Currency Swap
As net position is to borrow at 11
Swap Bank
US9.4
Firm B
Firm A
US8
12
A saves .6
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An Example of a Currency Swap
Bs net position is to borrow at US9.4
Swap Bank
US9.4
Firm B
Firm A
US8
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B saves .6
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An Example of a Currency Swap
1.4 of US16 million financed with 1 of 10
million per year for five years.
The swap bank makes money too
Swap Bank
US9.4
Firm B
Firm A
US8
At S0(/) 1.60/, that is a gain of
US124,000 per year for 5 years.
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The swap bank faces exchange rate risk, but maybe
they can lay it off (in another swap).
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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.

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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.

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Risks of Interest Rate and Currency Swaps

• Credit Risk
• This is the major risk faced by a swap dealerthe
  risk that a counter party will default on its end
  of the swap.
• Mismatch Risk
• Its 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.

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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.

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25.7 Actual Use of Derivatives

• Because derivatives dont 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.

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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.