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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

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Interest-Rate Forward Markets

Long position = agree to buy securities at future date

Hedges by locking in future interest rate if funds coming in future

Short position = agree to sell securities at future date

Hedges by reducing price risk from change in interest rates if holding bonds

Pros

1. Flexible

Cons

1. Lack of liquidity: hard to find counterparty

2. Subject to default risk: requires information to screen good from bad risk

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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 (individual securities) vs. macro hedge (entire portfolio)

Traded on Exchanges: Global competitionRegulated by Commodity Futures Trading Commission

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

securities2. Delivery of range of securities prevents corner (somebody buys out certain type of

security)3. Mark to market and margin requirements: avoids default risk4. Don’t have to deliver: netting

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Widely Traded Financial Futures Contracts

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Widely Traded Financial Futures Contracts

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Hedging FX Risk

Example: Customer due 10 million euro in two months, current rate: 1 euro = $11. Forward contract to sell 10 million euros for $10

million, two months in future

2. Sell 10 million of euro futures

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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

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Profits and Losses: Options vs. Futures

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

$115,000.2. Premium = $2,000

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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

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Interest-Rate Swap Contract

1. Notional principle of $1 million

2. Term of 10 years

3. Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Co.

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Hedging with Interest-Rate Swaps

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

assets, Rate Sens. Assets , lowers gap (liabilities-assets)2. 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