Chapter 13

Financial Derivatives

© 2006 Pearson Addison-Wesley. All rights reserved 13-2

Hedging

Hedge: engage in a financial transaction that reduces or eliminates risk

Basic hedging principle:Hedging risk involves engaging in a financial transaction that offsets a long position by taking a short position, or offsets a short position by taking a additional long position

© 2006 Pearson Addison-Wesley. All rights reserved 13-3

Interest-Rate Forward Markets

Long position = agree to buy securities at future dateHedges by locking in future interest rate if funds coming

in futureShort position = agree to sell securities at future dateHedges by reducing price risk from change in interest

rates if holding bondsPros1. FlexibleCons1. Lack of liquidity: hard to find counterparty2. Subject to default risk: requires information to screen

good from bad risk

© 2006 Pearson Addison-Wesley. All rights reserved 13-4

Financial Futures MarketsFinancial Futures Contract1. Specifies delivery of type of security at future date2. Arbitrage ⇒ at expiration date, price of contract = price of

the underlying asset delivered3. i ↑, long contract has loss, short contract has profit4. Hedging similar to forwards

Micro vs. macro hedge

Traded on Exchanges: Global competitionRegulated by CFTC

Success of Futures Over Forwards1. Futures more liquid: standardized, can be traded again,

delivery of range of securities2. Delivery of range of securities prevents corner3. Mark to market and margin requirements: avoids default

risk4. Don’t have to deliver: netting

13-5

Widely Traded Financial Futures Contracts

13-6

Widely Traded Financial Futures Contracts

© 2006 Pearson Addison-Wesley. All rights reserved 13-7

Hedging FX Risk

Example: Customer due 10 million DM in two months, current DM=$11. Forward contract to sell 10 million euros for $10

million, two months in future2. Sell 10 million of euro futures

13-8

Options

Options ContractRight to buy (call option) or sell (put option)

instrument at exercise (strike) price up until expiration date (American) or on expiration date (European)

Hedging with OptionsBuy same # of put option contracts as would

sell of futuresDisadvantage: pay premiumAdvantage: protected if i ↑, gain if i ↓Additional advantage if macro hedge: avoids accountingproblems, no losses on option when i ↓

13-9

Profits and Losses: Options vs. Futures

$100,000 T-bond contract,1. Exercise price of 115,

$115,000.2. Premium = $2,000

© 2006 Pearson Addison-Wesley. All rights reserved 13-10

Factors Affecting Premium

1.Higher strike price ⇒ lower premium on call options and higher premium on put options

2.Greater term to expiration ⇒ higher premiums for both call and put options

3.Greater price volatility of underlying instrument ⇒ higher premiums for both call and put options

© 2006 Pearson Addison-Wesley. All rights reserved 13-11

Interest-Rate Swap Contract

1. Notional principle of $1 million2. Term of 10 years3. Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Co.

© 2006 Pearson Addison-Wesley. All rights reserved 13-12

Hedging with Interest-Rate Swaps

Reduce interest-rate risk for both parties1. Midwest converts $1m of fixed rate assets to rate-

sensitive assets, RSA ↑, lowers GAP2. Friendly Finance RSA ↓, lowers GAP

Advantages of swaps1. Reduce risk, no change in balance-sheet2. Longer term than futures or options

Disadvantages of swaps1. Lack of liquidity2. Subject to default risk

Financial intermediaries help reduce disadvantages of swaps