Derivatives and Risk Management

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Derivatives and Risk Management
Greg LaFlame 4/7/03
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Risk Management

• Types of Risk
• Pure Risks
• Speculative Risks
• Demand Risks
• Input Risks
• Financial Risks
• Property Risks
• Personal Risks
• Environmental Risks
• Liability Risks
• Insurable Risks

• Approach to RM
• Identify
• Measure
• Mitigate transfer exposure transfer
  function purchase derivative reduce
  probability avoid related activity

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1998 Wharton Survey of Financial Risk Management
by U.S. Non-Financial Firms
Reasons to manage risks - Debt capacity - reduce
volatility of cash flows, risk on bankruptcy -
Maintenance of optional capital budget -
smoothing our cash flows - Financial distress -
cash flows stay above distress level -
Comparative advantages in hedging - risk
management supports proper hedging - Borrowing
costs - reduce vis hedging - Tax effects - via
stable earnings, improved use of tax
carry-carrforwards and carry-backs -
Compensation systems - stable earnings improve
probability of bonus payments
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Derivatives in the News
Procter Gamble
Barings and Sumitomo
Long Term Capital Management
Orange County, California
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Types of derivatives - a sample
Options - calls and puts - buyer has option to
exercise option, seller committed.
Forward contracts - over-the-counter customized
agreements stating future price, date and
quantity - commodity is normally delivered.
Futures contracts - exchange-traded standardized
contracts stating future price, date and
quantity - commodity normally not delivered -
offset.
Swaps - parties agree to swap payment streams -
normally used to swap fixed for variable
interest rate commitment.
Structured Notes - debt obligations that are
derived from other debt obligations. For
example, zeros support by U.S. Treasuries and
Collateralized Mortgage Bonds.
Inverse Floaters - notes where the rate paid
moves counter to market rates.
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Call Option Example the option is struck
when the value of the underlying is above the
strike price
Option Profit

Strike Price
Value of Underlying
Premium
-
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Put Option Example the option is struck when
the value of the underlying is below the
strike price
Option Profit
Strike Price

Value of Underlying
Premium
-
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Forward Contract An agreement between two
parties to establish a price and quantity of a
commodity to be transferred at a future date.
Forward Profit
Long Forward

Value of Underlying
-
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We can create a synthetic call option by using a
put option and a forward.
Forward Profit
Here we add a Put Option
Long Forward

Value of Underlying
-
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Interest Rate SWAPS
Situation 1 - Carter issues floating debt, Brence
issues fixed. Good deal for both!
Carter LIBOR 2 payt to nvestors - LIBOR
payt from Bre. 7.95 payt to
Brence 9.95 Net Cost
Brence - 7.95 pay from Carter LIBOR
payt to Carter 11.0 payt to
Investors LIBOR 3.05 Net Cost
Fixed
Floating
LIBOR 3.05is less than LIBOR 3.10
9.95 less than 10
Situation 2 - Carter issues fixed debt, Brence
issues floating debt.
Carter - 7.95 LIBOR 10.00 LIBOR 2.05

Brence 7.95 LIBOR 3.1 - LIBOR
11.05
Floating
Fixed
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Hedging bond issue with futures
Expected Bond Issue
Short Futures
Interest Rates
Proceeds
Interest Rates
Value
There exists an inverse relationship between
Future Bond Issue proceeds and the short
futures position - position is hedged!
Lets see how this works by using an example!
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Given a Treasury Bond (100,000) and settled at
100-16, what is implied interest Rate? (note
bond prices are quoted in 32 nds)
Futures price 100,500 N40, Payment 60/2
30 PV -1005 FV 1,000 Use calculator.
Implied interest rate 5.96
If interest rates increase by 100 basis points
what is value of Futures?
Interest rates cause implied interest rate to
increase from 5.96 to 6.96. Use calculator,
input new yield, calculate PV. PV 897.18 -
convert to total amount of 89,718 Starting
value 100,500 Ending value 89,718 Gain
10,752
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Assumptions
Current Time November, 00 Interest Rate
11 Want to sell 10 M of bonds in June
01 Interest rate restricted to 11 Treasury
Bonds for June 95 17/32
Future Time June 01 Sell bonds subject to
interest rate restrictions
Step 1 - Take short position on June 01 futures
position to equal bond offering Sell 100
contracts (100,000 each) _at_ 95 17/32 9,553,130
Step 2 - Assume that interest rates increase by
200 basis points by June 01
Use calculator N20, I13 /2, PMT 11 /2 X
10,000,000 550,000, FV
10,000,000. Solve for PV equals 8,898,447.
This is the amount of proceeds given
interest rate restriction
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Step 3 - Value Futures Contract (note that
hypothetical bond is for maturity
is 20 years at 6). Use calculator PV
-9,553,130, FV 10,000,000, N 40, I 6
(300,000), Yield 6.40. Step 4 -
Increase yield by 200 basis points (6.40 2.00
8.40). Recalculate PV FV 10,000,000, N
40, Coupon 300,000, I/Y
8.40 /2, PV 7,693,948
Summary Gain on Futures Loss on
Interest 9,553,130 10,000,000 7,693,948
8,898,149 1,859,182 1,101,851 Net Gain
757,331