derivatives, and risk management, left hand financing
TRANSCRIPT
DERIVATIVES, AND RISK MANAGEMENT, LEFT-HAND
FINANCING, AND LEVERAGED BUYOUT
Group 1
Jerold SaddiPamela Bernabe
Juliet delos SantosJenelle Canonizado
Elvin Lee
June 30, 2012
Learning Objectives: After this session the FINMAN students
would be able to: Know all necessary concepts regarding
derivatives Know all various left-hand financing schemes,
including their advantages and disadvantages Know the mechanics of Leveraged buyout, its
use, it’s advantages and disadvantages
June 30, 2012
What are derivatives?
Are financial instrument that “derive” their value from contractually required cash flows from some other security or index.
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Example
http://www.youtube.com/watch?v=FLGRPYAtReo
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What are the essential features of a derivative? A derivative is a financial instrument
Values changes in response to the changes in UNDERLYING variables.
No or minimum initial net investment
Settled at a future date by a net cash payment / settlement
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What are the kinds/examples of derivatives? Option Contract Forward Contract Futures Contract Foreign Currency Exchange Contract Interest Rate Swap
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Accounting for Derivatives Are to be considered as either assets or
liabilities and should be reported in the balance sheet at fair value.
Unrealized gain or loss from fedging transactions is presented depending on the type of hedging. Under the Fair Value hedge method – part of
income Under Cash Flow Hedge Method – part of
EQUITY
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For foreign entity investment: Changes in fair Value determined to be an
effective hedge are recognized in EQUITY.
The ineffective portion of the changes in fair value are recognized in EARNINGS IMMEDIATELY if the hedging instrument is a derivative.
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Why do derivatives exist? Hedging - Pertains to designating one or
more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item.
http://www.youtube.com/watch?v=kBtrxAjtG04
June 30, 2012
FORWARD CONTRACT A transaction in which a seller agrees to
deliver a specific commodity to a buyer at some point in the future.
Read more: http://www.investorwords.com/2060/forward_contract.html#ixzz1zDZdjqWa
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Example
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Pamela Bernabe
Call/ put OptionsFinancial Futures
June 30, 2012
A derivatives financial instrument that specifies a contract giving its owner the right to buy or sell an asset at a fixed price on or before a given date.
Its also a unique type of financial contract because they give the buyer the right, but not the obligation, to do something.
The buyer uses the option only if it is adventageous to do so; otherwise the option can be thrown away
Give the marketplace opportunities to adjust risk or alter income streams that would otherwise not be available
Provide financial leverage
Can be used to generate additional income from investment portfolios
OPTIONS
June 30, 2012
Thales – ancient Greek philosopher
LOW STRIKE
OLIVE SEASON – HIGH
June 30, 2012
EXAMPLE
Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season's olive harvest would be larger than usual, and during the off-season he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at much higher price than he paid for his 'option'.
June 30, 2012
OPTION TERMINOLOGY
• Option Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option.
• Option Buyer - One who buys the option. He has the right to exercise the option but no obligation.
• Call Option - Option to buy.
• Put Option - Option to sell. Call Option Put Option
Option Buyer Buys the right to buy the underlying asset at the Strike Price
Buys the right to sell the underlying asset at the Strike Price
Option Seller Has the obligation to sell the underlying asset to the option holder at the Strike Price
Has the obligation to buy the underlying asset from the option holder at the Strike Price
June 30, 2012
OPTION TERMINOLOGY• American Option - An option which can be
exercised anytime on or before the expiry date. • Strike Price/ Exercise Price - Price at which the
option is to be exercised.
• Expiration Date - Date on which the option expires.
• European Option - An option which can be exercised only on expiry date.
• Exercise Date - Date on which the option gets exercised by the option holder/buyer.
• Option Premium - The price paid by the option
buyer to the option seller for granting the option.
June 30, 2012
CALL OPTIONSA call option gives you the right to buy
within a specified time period at a specified price
The owner of the option pays a cash premium to the option seller in exchange for the right to buy
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PRACTICAL EXAMPLE OF A CALL OPTION
June 30, 2012
CALL OPTIONS - ILLUSTRATION
An investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity.
On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.
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June 30, 2012
PUT OPTIONSA put option gives
you the right to sell within a specified time period at a specified price
It is not necessary to own the asset before acquiring the right to sell it
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An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.
June 30, 2012
June 30, 2012
CALL/PUT OPTIONS Call Option Put Option
Option Buyer Buys the right to buy the underlying asset at the Strike Price
Buys the right to sell the underlying asset at the Strike Price
Option Seller Has the obligation to sell the underlying asset to the option holder at the Strike Price
Has the obligation to buy the underlying asset from the option holder at the Strike Price
June 30, 2012
All exchange-traded options have standardized expiration dates The Saturday following the third Friday of
designated months for most options
Investors typically view the third Friday of the month as the expiration date
The striking price of an option is the predetermined transaction price
In multiples of $2.50 (for stocks priced $25.00 or below) or $5.00 (for stocks priced higher than $25.00)
There is usually at least one striking price above and one below the current stock price
STANDARDIZED OPTION CHARACTERISTICS
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Puts and calls are based on 100 shares of the underlying security
The underlying security is the security that the option gives you the right to buy or sell
It is not possible to buy or sell odd lots of options
STANDARDIZED OPTION CHARACTERISTICS
June 30, 2012
FINANCIAL FUTURES
Forwards – a contract that is customized between two entities, where settlement takes place on a specific date in the future at today’s pre-agreed price
Futures – an agreement between two parties to buy or sell an asset to a certain time in the future at a certain price.
- it is also a special types of forward contracts in the sense that the former standardized exchange-traded contracts.
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SIMPLE EXAMPLE
If you agree in April with your Aunt Sue that you will buy two pounds of tomatoes from her garden for $5, to be delivered to you when they're ripe in July, you and Sue just entered into a futures contract.
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A financial future is a futures contract on a short term interest rate (STIR). Contracts vary, but are often defined on an interest rate index such as 3-month sterling or US dollar LIBOR.
They are traded across a wide range of currencies, including the G12 country currencies and many others.
The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of today's commodity markets.
FINANCIAL FUTURES
June 30, 2012
Some representative financial futures contracts are:United States 90-day Eurodollar *(IMM) 1 mo LIBOR (IMM) Fed Funds 30 day (CBOT)Europe 3 mo Euribor (Euronext.liffe) 90-day Sterling LIBOR (Euronext.liffe) Euro Sfr (Euronext.liffe)Asia 3 mo Euro yen (TIF) 90-day Bank Bill (SFE)where IMM is the International Money Market of the Chicago Mercantile
Exchange CBOT is the Chicago Board of Trade TOCOM is the Tokyo Commodity Exchange SFE is the Sydney futures exchange
FINANCIAL FUTURES
June 30, 2012
COMPARISON OF FUTURES AND FORWARD
FuturesFutures ForwardForwardAmountAmount StandardizedStandardized NegotiatedNegotiated
Delivery DateDelivery Date StandardizedStandardized NegotiatedNegotiated
Counter-partyCounter-party ClearinghouseClearinghouse BankBank
CollateralCollateral Margin Acct.Margin Acct. NegotiatedNegotiated
MarketMarket Auction MarketAuction Market Dealer MarketDealer Market
CostsCosts Brokerage and Brokerage and exchange feesexchange fees
Bid-ask spreadBid-ask spread
LiquidityLiquidity Very liquidVery liquid Highly illiquidHighly illiquid
RegulationRegulation GovernmentGovernment Self-regulatedSelf-regulated
LocationLocation Central Central exchangeexchange
WorldwideWorldwide
June 30, 2012
ADVANTAGE AND DISADVANTAGE OF FINANCIAL FUTURES
Advantages Small Contract Size Easy liquidation Well organized and stable market (no risk of default)
Disadvantages Limited number of currencies (but think about how one
futures might be a close hedge against another currency) Rigid contract size Fixed expiration dates (but if you can get close, it doesn’t
matter all that much).
June 30, 2012
THERE ARE TWO TYPES OF ORGANIZATIONS THAT FACILITATE FUTURES TRADING:
ExchangeExchanges are non-profit or for-profit organizations that offer standardized futures contracts for physical commodities, foreign currency and financial products.
ClearinghouseA clearinghouse is agency associated with an exchange, which settles trades and regulates delivery. Clearinghouses guarantee the fulfillment of futures contract obligations by all parties involved.
June 30, 2012
AN EXAMPLE:90-DAY EURODOLLAR TIME DEPOSIT FUTURES Eurodollar futures contracts are traded on the
International Monetary Market (IMM), a division of the Chicago Mercantile Exchange.
The underlying asset is a Eurodollar time deposit with a 3-month maturity. Eurodollar rates are quoted on an interest-bearing
basis, assuming a 360-day year. Each Eurodollar futures contract represents $1 million
of initial face value of Eurodollar deposits maturing three months after contract expiration.
Forty separate contracts are traded at any point in time, as contracts expire in March, June, September and December
June 30, 2012
AN EXAMPLE:90-DAY EURODOLLAR TIME DEPOSIT FUTURES
Eurodollar futures contracts trade according to an index that equals 100 percent minus the futures interest rate expressed in percentage terms.
An index of 91.50 indicates a futures rate of 8.5 percent.
Each basis point change in the futures rate equals a $25 change in value of the contract (0.0001 x $1 million x 90/360).
June 30, 2012
E st v ol 136,182; v ol F ri 227,588; open int 2,963,996, 111,645.
3-M O . E U R O D O LLA R (C M E )-$1 M ILLIO N ; P TS O F 100%
July A ug S ept O c t N ov D ec M r99 June S ept D ec M r00 June S ept D ec M r01 June S ept D ec M r02 June S ept D ec M r03 June S ept D ec M r04 June S ept D ec M r05 June S ept D ec M r06 June S ept D ec M r07 June S ept D ec M r08 June
O pen 94.30 94.31 94.31
. . . . .
. . . . . 94.26 94.31 94.30 94.26 94.17 94.21 94.18 94.17 94.09 94.12 94.11 94.10 94.03 94.07 94.05 94.04 93.97 94.01 93.99 93.98 93.91 93.94
. . . . . 93.91
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . . 93.69
. . . . .
. . . . .
. . . . .
. . . . .
H igh 94.31 94.31 94.31
. . . . .
. . . . . 94.27 94.31 94.30 94.27 94.17 94.21 94.18 94.17 94.09 94.13 94.11 94.10 94.04 94.07 94.06 94.05 93.98 94.01 93.99 93.98 93.91 93.94
. . . . . 93.91
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . . 93.69
. . . . .
. . . . .
. . . . .
. . . . .
Low 94.30 94.31 94.30
. . . . .
. . . . . 94.24 94.28 94.28 94.26 94.15 94.20 94.17 94.15 94.08 94.12 94.10 94.09 94.02 94.06 94.04 94.04 93.96 94.00 93.98 93.98 93.91 93.94
. . . . . 93.91
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . .
. . . . . 93.69
. . . . .
. . . . .
. . . . .
. . . . .
S ettle 94.31 94.31 94.31 94.27 94.27 94.26 94.31 94.28 94.26 94.16 94.21 94.18 94.16 94.09 94.12 94.11 94.10 94.03 94.07 94.05 94.04 93.97 94.01 93.99 93.98 93.91 93.94 93.91 93.89 93.82 93.85 93.83 93.81 93.74 93.77 93.74 93.72 93.65 93.68 93.66 93.64 93.57 93.60 93.57
C hg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
1 .01 1 .01 1 .01 1 .01 1 .01
S ettle 5.69 5.69 5.69 5.73 5.73 5.74 5.69 5.72 5.74 5.84 5.79 5.82 5.84 5.91 5.88 5.89 5.90 5.97 5.93 5.95 5.96 6.03 5.99 6.01 6.02 6.09 6.06 6.09 6.11 6.18 6.15 6.17 6.19 6.26 6.23 6.26 6.28 6.35 6.32 6.34 6.36 6.43 6.40 6.43
C hg . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .
2 .01 2 .01 2 .01 2 .01 2 .01
Yield O penInter es t 31,182
9,380 510,606
2,192 672
387,531 325.342 269,641 229,075 190,832 159,139 143,007
87,251 73,205 67,222 58,341 47,362 41,415 46,012 45,815 43,184 32,736 28,812 20,373 15,864
8,744 7,505 8,553 6,938 7,397 5,576 5,323 4,250 3,735 5,816 3,648 4,709 5,331 4,075 4,205 4,619 3,680 3,406
295
The first column indicates the settlement month and year.
Each row lists price and yield data for a distinct futures contract that expires sequentially every three months.
The next four columns report the opening price, high and low price, and closing settlement price.
The next column, headed Chg, states the change in settlement price from the previous day.
The two columns under Yield convert the settlement price to a Eurodollar futures rate as:100 - settlement price =
futures rate
EURODOLLAR FUTURES
June 30, 2012
SPECULATING WITH FUTURES, LONG Buying a futures contract (today) is often referred to as
“going long,” or establishing a long position.
Recall: Each futures contract has an expiration date.
Every day before expiration, a new futures price is established.
If this new price is higher than the previous day’s price, the holder of a long futures contract position profits from this futures price increase.
If this new price is lower than the previous day’s price, the holder of a long futures contract position loses from this futures price decrease.
June 30, 2012
EXAMPLE I: SPECULATING IN GOLD FUTURES You believe the price of gold will go up. So,
You go long 100 futures contract that expires in 3 months. The futures price today is $400 per ounce. There are 100 ounces of gold in each futures contract.
Your "position value" is: $400 X 100 X 100 = $4,000,000
Suppose your belief is correct, and the price of gold is $420 when the futures contract expires.
Your "position value" is now: $420 X 100 X 100 = $4,200,000
Your "long" speculation has resulted in a gain of $200,000
What would have happened if the gold price was $370?
June 30, 2012
SPECULATING WITH FUTURES, SHORT Selling a futures contract (today) is often called
“going short,” or establishing a short position.
Recall: Each futures contract has an expiration date.
Every day before expiration, a new futures price is established.
If this new price is higher than the previous day’s price, the holder of a short futures contract position loses from this futures price increase.
If this new price is lower than the previous day’s price, the holder of a short futures contract position profits from this futures price decrease.
June 30, 2012
EXAMPLE II: SPECULATING IN GOLD FUTURES You believe the price of gold will go down. So,
You go short 100 futures contract that expires in 3 months. The futures price today is $400 per ounce. There are 100 ounces of gold in each futures contract.
Your "position value" is: $400 X 100 X 100 = $4,000,000
Suppose your belief is correct, and the price of gold is $370 when the futures contract expires.
Your “position value” is now: $370 X 100 X 100 = $3,700,000
Your "short" speculation has resulted in a gain of $300,000
What would have happened if the gold price was $420?
June 30, 2012
INTEREST RATE SWAPS
Juliet Delos Santos
June 30, 2012
Swaps Contracts
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.
June 30, 2012
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.
June 30, 2012
Example: 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 $10,000,000 to finance floating-rate Eurodollar loans. Bank A is considering issuing 5-year fixed-rate Eurodollar
bonds at 10 percent. It would make more sense to for the bank to issue
floating-rate notes at LIBOR (London Interbank Offered Rate) to finance floating-rate Eurodollar loans.
June 30, 2012
Example: Interest Rate Swap (cont.)Firm B is a BBB-rated U.S.
company. It needs $10,000,000 to finance an investment with a five-year economic life. Firm B is considering issuing 5-year fixed-rate
Eurodollar bonds at 11.75 percent. Alternatively, firm B can raise the money by issuing
5-year floating-rate notes at LIBOR + ½ percent. Firm B would prefer to borrow at a fixed rate.
June 30, 2012
Example: Interest Rate Swap (cont.)The borrowing opportunities of the
two firms are:
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
June 30, 2012
The swap bank makes this offer to Bank A: You pay LIBOR – 1/8 % per year on $10M for 5 yrs. and we will pay you 10 3/8% on $10M for 5 yrs.
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Swap
Bank
LIBOR – 1/8%
10 3/8%
Bank A
Example: Interest Rate Swap (cont.)
June 30, 2012
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Here’s what’s in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of
-10 3/8 + 10 + (LIBOR – 1/8) =
LIBOR – ½ % which is ½ % better than they can borrow floating without a swap.
10%
½% of $10M = $50K. That’s quite a cost savings per yr. for 5 yrs.
Swap
Bank
LIBOR – 1/8%
10 3/8%
Bank
A
Example: Interest Rate Swap (cont.)
June 30, 2012
Company
B
The swap bank makes this offer to company B: You pay us 10½% per year on $10 million for 5 years and we will pay you LIBOR – ¼ % per year on $10 million for 5 years.
Swap
Bank10 ½%
LIBOR – ¼%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Example: Interest Rate Swap (cont.)
June 30, 2012 25-51
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
They can borrow externally at
LIBOR + ½ % and have a net borrowing position of 10½ + (LIBOR + ½ ) - (LIBOR - ¼ ) = 11.25% which is ½% better than they can borrow floating.
LIBOR + ½%
Here’s what’s in it for B:
½ % of $10M = $50K that’s quite
a cost savings per yr. for 5 yrs.
Swap
Bank
Company
B
10 ½%
LIBOR – ¼%
Example: Interest Rate Swap (cont.)
June 30, 2012 25-52
The swap bank makes money too.
¼% of $10M= $25,000 per yr. for 5 yrs.
LIBOR – 1/8 – [LIBOR – ¼ ]= 1/8
10 ½ - 10 3/8 = 1/8
¼
Swap
Bank
Company
B
10 ½%
LIBOR – ¼%LIBOR – 1/8%
10 3/8%
Bank
A
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Example: Interest Rate Swap (cont.)
June 30, 2012 25-53
Swap
Bank
Company
B
10 ½%
LIBOR – ¼%LIBOR – 1/8%
10 3/8%
Bank
AB saves ½
%A saves ½%
The swap bank makes ¼%
COMPANY B BANK A
Fixed rate 11.75% 10%
Floating rate LIBOR + .5% LIBOR
Example: Interest Rate Swap (cont.)
June 30, 2012
Example: Currency Swap
Suppose a U.S. MNC wants to finance a £10M expansion of a British plant.
They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds. This will give them exchange rate risk: financing a
sterling project with dollars.
They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.
June 30, 2012
Example: Currency Swap (cont.) If they can find a British MNC with a mirror-
image financing need they may both benefit from a swap.
If the spot exchange rate is S0($/£) = $1.60/£, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16M.
June 30, 2012
Example: Currency Swap (cont.)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 other’s country of the same size. Their borrowing opportunities are given in the table below.
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
June 30, 2012
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Example: Currency Swap (cont.)
$8% £12%
Firm
B
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
A’s net position is to borrow at £11%
A savaes £.6%
June 30, 2012
Example: Currency Swap (cont.)
$8% £12%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Firm
B
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
B’s net position is to borrow at $9.4%
B saves $.6%
June 30, 2012
Example: Currency Swap (cont.)
$8% £12%
$ £
Company A 8.0% 11.6%
Company B 10.0% 12.0%
Firm
B
The swap bank makes money too:
At S0($/£) = $1.60/£, that is a gain of $64,000 per year for 5 years.
The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).
1.4% of $16 million
financed with 1% of £10
million per year for 5
years.
Swap
Bank
Firm
A
£11%
$8% $9.4%
£12%
June 30, 2012
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.
June 30, 2012 25-61
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.
June 30, 2012
Risks of Interest Rate and Currency Swaps Credit Risk
This is the major risk faced by a swap dealer—the risk that a counter party will default on its end of the swap.
Mismatch Risk It’s 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.
June 30, 2012
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.
June 30, 2012
Derivatives Prevailing in the Philippine Market Forward Swap (Interest or Asset) Options Credit-Linked Notes Structured Product –Structured Yield
Deposit
Source: BSP Circular 594
June 30, 2012
What is corporate risk management, and why is it important to all firms? Corporate risk management relates to the
management of unpredictable events that would have adverse consequences for the firm.
All firms face risks, but the lower those risks can be made, the more valuable the firm, other things held constant. Of course, risk reduction has a cost.
June 30, 2012
Definitions of different types of risk
Speculative risks – offer the chance of a gain as well as a loss.
Pure risks – offer only the prospect of a loss. Demand risks – risks associated with the
demand for a firm’s products or services. Input risks – risks associated with a firm’s
input costs. Financial risks – result from financial
transactions.
June 30, 2012
Definitions of different types of risk
Property risks – risks associated with loss of a firm’s productive assets.
Personnel risk – result from human actions. Environmental risk – risk associated with
polluting the environment. Liability risks – connected with product,
service, or employee liability. Insurable risks – risks that typically can be
covered by insurance.
June 30, 2012
What are the three steps of corporate risk management?1. Identify the risks faced by the firm.2. Measure the potential impact of the
identified risks.3. Decide how each relevant risk should
be handled.
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What can companies do to minimize or reduce risk exposure?
Transfer risk to an insurance company by paying periodic premiums.
Transfer functions that produce risk to third parties.
Purchase derivative contracts to reduce input and financial risks.
Take actions to reduce the probability of
occurrence of adverse events and the magnitude
associated with such adverse events.
Avoid the activities that give rise to risk.
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Leasing and Other Asset-Based Financing
Corporate Financial Management 3e Emery Finnerty Stowe
Modified for course use by Arnold R. Cowan
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Lease Financing A lease is a rental agreement that extends for
one year or longer. The owner of the asset (the lessor) grants
exclusive use of the asset to the lessee for a fixed period of time. In return, the lessee makes fixed periodic payments to
the lessor. At termination, the lessee may have the option to
either renew the lease or purchase the asset.
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Types of Leases
Full-service lease Lessor responsible for maintenance, insurance,
and property taxes. Net lease
Lessee responsible for maintenance, insurance, and property taxes.
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Types of Leases
Operating lease short-term may be cancelable
Financial lease long-term similar to a loan agreement
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Types of Lease Financing
Direct leases Sale-and-lease-back agreements Leveraged leases
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Direct Lease
Lessee Manufacturer/ Lessor
Lease
Lessee LessorLease Sale of Asset Manufacturer/ Lessor
or
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Sale-and-Lease-Back
Sale of Asset
Lease
Lessee Lessor
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Leveraged Lease
LenderLien
Equity Investor
Lessee Lease
Single Purpose Leasing
Company
Manufacturer
Sale of A
sset
Equity
Loan
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Synthetic Leases
Firms have used synthetic leases to get the use of assets but keep debt off their balance sheets.
An unrelated financial institution invests some equity and sets up a special-purpose-entity that buys the assets and leases it to the firm under an operating lease.
Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.
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Advantages of Leases Efficient use of tax deductions and tax credits of
ownership Reduced risk Reduced cost of borrowing Bankruptcy considerations Tapping new sources of funds Circumventing restrictions
debt covenants off-balance sheet financing
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Disadvantages of Leasing
Lessee forfeits tax deductions associated with asset ownership.
Lessee usually forgoes residual asset value.
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Valuing Financial Leases Basic approach is similar to debt refunding. Lease displaces debt. Missed lease payments can result in the lessor
claiming the asset. filing lawsuits. forcing firm into bankruptcy.
Risk of a firm’s lease payments are similar to those of its interest and principal payments.
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Project Financing
Desirable when Project can stand alone as an economic unit. Project will generate enough revenue (net of
operating costs) to service project debt. Examples:
Mines & mineral processing facilities Pipelines Oil refineries Paper mills
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Project Financing Arrangements Completion undertaking Purchase, throughput, or tolling
agreements Cash deficiency agreements
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Advantages and Disadvantages of Project Financing
Advantages Risk sharing Expanded debt capacity Lower cost of debt
Disadvantages Significant transaction costs and legal fees Complex contractual agreements Lenders require a higher yield premium
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Limited Partnership Financing
Another form of tax-oriented financing. Allows the firm to “sell” the tax
deductions and credits associated with asset ownership to the limited partners.
Income (or loss) for tax purposes flows through to the partners.
Limited partners are passive investors. General partner operates the limited
partnership and has unlimited liability.
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Leveraged Buyouts (LBO)
• LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO.
• LBOs are financed with large amounts of borrowing (leverage), hence its name.
• LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company.
• After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.
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History: LBO
• Leveraged buyouts were a relatively obscure means of financing large corporate acquisitions in the post WWII period. The practice positively boomed in the 1980s, with a combined $188 billion in acquisitions taking place in 1988 alone. The term “hostile takeover” coined during this period, it reflects the mixed feelings towards LBO.
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Successful LBO Strategies• Finding cheap assets – buying low
and selling high (value arbitrage or multiple expansion)
• Unlocking value through restructuring:
– Financial restructuring of balance sheet – improved combination of debt and equity
– Operational restructuring – improving operations to increase cash flows
Key Terms and concepts regarding LBOs:
•Transaction fee amortization. This reflects the capitalization and amortization of financing, legal, and accounting fees associated with the transaction.
- its like depreciation, is a tax-deductible noncash expense.
•Interest Expense- For simplicity, interest expense for each tranche of debt financing is calculated based on the yearly beginning balance of each tranche.
•Capitalization. Most leveraged buyouts make use of multiple tranches of debt to finance the transaction. A simple transaction may have only two tranches of debt, senior and junior. A large leveraged buyout will likely be financed with multiple tranches of debt that could include some or all of the following:
• Revolving credit facility (revolver). This is a source of funds that the bought-out firm can draw upon as its working capital needs dictate.
• Bank debt. Often secured by the assets of the bought-ought firm, this is the most senior claim against the cash flows of the business.• Mezzanine Debt – exists in the middle of the capital structure and is junior to the bank debt incurred in financing the leveraged buyout.•Subordinated or high yield notes (junk bonds) – most junior source of debt financing and as such has the highest interest rates.•Cash Sweep - is a provision of certain debt covenants that stipulates that any excess cash generated by the bought out business will be used to pay down principal.•Exit Scenario – usually involves either a sale of portfolio company or recapitalization.
