Hedging Strategies: The Financials

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Hedging Strategies The Financials
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Interest Rate Futures

• In this chapter, we will be talking about
  interest rate futures contract and hedging.
• Two concepts necessary for a good understanding
  of interest rate futures.
• Price/Rate Relationships
• Yield curves

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Price/Rate Relationships

• A fixed rate bonds price varies inversely with
  interest rates.
• If rate increases, the price of bond decreases
  and vice-versa.
• Example If a two year 1,000 bond (face value)
  has a coupon of 10, then the holder will receive
  100 annually for two years and receive 1,000
  principal at the end of two years.

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Price/Rate Relationships

• If the current market rate is 10 percent, then
  discounted value of the bond is
• 100/1.11,100/(1.1)2 90.91909.09 999.99
• If the market rate increases to 12, then the
  bond price falls to 966.20.

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Price/Rate Relationships

• New issue bonds would have to be issued with a
  coupon near the new market levels to be
  competitive.

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Yield Curves

• A yield curve is simply a graphical
  representation of the yields of different
  maturities of the same or near same debt
  instruments.

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Yield curve for treasury bills
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Interest Rate Hedging

• The first financial futures contract involving
  interest rate began trading in October 1975. The
  timing of the initial futures contract.
• The timing of the contract coincided with the
  increased inflation in the U.S. economy and
  increased volatility in interest rates.

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The Mechanics of Interest Rate Hedge

• There is no direct interest rate futures
  contracts.
• The hedger must use Treasury bills, notes or
  bonds or some other financial bonds.
• Example
• A bank issues a one year CD to an individual who
  placed 1,000,000 in the bank with an agreement
  that bank will pay interest at the rate of 6
  percent per year.

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The Mechanics of Interest Rate Hedge

• The bank will then loan the amount to a borrower
  at an interest rate sufficient to cover the six
  percent to be paid to the CD owner and banks
  operating cost.
• However, anticipating a rate decline, the
  borrower demands for a variable rate loan that
  will be set for six month (7.5 percent) and then
  be adjusted at the end of six month.

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The Mechanics of Interest Rate Hedge

• In this situation, bank is exposed to interest
  rate risk and needs to hedge against the downward
  interest rate risk.
• To hedge, bank would need to buy T-bill futures.

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• Treasury bonds are quoted in dollars and
  thirty-seconds of a dollar.
• The quoted price is for a bond with a face value
  of 100.
• Thus a quote of 90-05 means that the indicated
  price for a bond with a face value of 100,000 is
  90,156.25.
• Similarly, a quote of 99-30 with a face value of
  100,000 is _________.

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• The quoted price is not the same as the cash
  price that is paid by the purchaser.
• Cash price quoted price Accrued interest
  since the last coupon date.
• To illustrate the formula
• Suppose that it is March 5, 2001 and the bond
  under consideration is a 11 percent coupon bond
  maturing on July 10, 2005 with a quoted price of
  95-16.
• For government bonds, coupons are paid
  semiannually. The most recent coupon date is
  January 10, 2001 and the next date is July 10,
  2001.

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• The number days between Jan. 10 and March 5 is
  54, whereas the number of days between Jan.10 and
  July 10 is 181.
• On a bond with a face value of 100, the coupon
  payment is 5.5 on Jan.10 and July 10.
• The accrued interest on March 5 5.554/181
  1.64
• The cash price per 100 face value for the July
  10, 2005 bond is therefore
• 95.51.6497.14
• Thus the cash price of 100,000 bond is 97, 140.

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Currency Hedging

• Futures contracts on international currencies
  began trading in 1972.
• The foreign currency market has a very active and
  liquid forward contract market that allows firms
  to hedge against exchange rate risk.

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Short Hedging

• A U.S. firm that has an export sale to U.K. with
  payment to be made in British pounds faces the
  risk that pound, relative to dollar, will
  depreciate.
• Example At the current rate of 1.4 per pound,
  U.S. exporter has agreed to receive 100,000
  pounds (140,000) for the merchandise. If the
  exchange rate changes to 1.35, the exporter
  still receives 100,000 pounds. But exchange rate
  fluctuations has reduced his profit by 5,000.

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Currency Hedging

• Similarly, if you are foreign investor, then you
  are faced with the risk of dollar appreciation.
• Example An investor is planning to invest
  100,000 U.S. dollars in Canada at the current
  exchange rate of 0.9 U.S. per Canadian dollar.
• Investor is expected to earn 3,000 C in three
  months.
• If the exchange rate remains at the current rate,
  he will earn (111,1113,000) Canadian dollars or
  102,700 U.S. dollar
• If the exchange rate appreciates to 0.85, then he
  will earn 114,111C or 96, 995 U.S. .

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Long Hedging

• Long Hedging protects against dollar depreciating
  relative to other currencies.
• This typically involves selling a foreign
  currency and buying dollars and then later
  selling the dollars and buying foreign currency.

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