Chapter 24Fundamentals of
Corporate
Finance
Fifth Edition
Slides by
Matthew Will
McGraw-Hill/Irwin Copyright © 2007 by The McGraw-Hill Companies, Inc. All rights reserved
Risk Management
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Topics Covered
Why Hedge?Reducing Risk with OptionsFutures ContractsForward ContractsSwapsInnovation in the Derivatives MarketIs “Derivative” a Four-Letter Word?
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Why Hedge?
Question of The DayWhat is a cereal company in the business of
doing?
A. Producing a product efficiently and selling it for
a profit.
B. Speculating on the price of sugar, wheat, and other
inputs to its product.
Answer: Both
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Why Hedge?
Question of The DayThe company does A. by choice and B. because
it has no choice.
The company can eliminate B through Hedging
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Reducing Risk With Options
Example - Onnex sells crude oil. Since its costs are relatively fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses.
How might Onnex hedge this risk?
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Reducing Risk With OptionsExample - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses.
How might Onnex hedge this risk?
Price per barrel
Onnex’s loses money when prices drop.
Rev
enue
s
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Reducing Risk With OptionsExample - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses.
How might Onnex hedge this risk?
Price per barrel
A put option makes money
when prices drop.
Rev
enue
s
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Reducing Risk With OptionsExample - Onnex sells crude oil. Since its costs are relatively
fixed, fluctuations in the sale price of crude oil can cause unexpected profits or losses.
How might Onnex hedge this risk?
Price per barrel
Onnex’s natural risk, plus a put
option provides a HEDGE against price declines.
Rev
enue
s
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Futures Contracts
Futures Contract - Exchange traded forward contract with gains or losses realized daily.
Profit to seller
= initial futures price - ultimate market price
Profit to buyer
= ultimate market price - initial futures price
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Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market.
Show the positions involved in this hedge.
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Future Contracts
The farmer loses money when the
price drops
Price per bushel
Val
ue o
f w
heat
Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market.
Show the positions involved in this hedge.
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Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market.
Show the positions involved in this hedge.
The futures contract profits
when prices drop
Price per bushel
Val
ue o
f w
heat
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Future Contracts
Example - The Farmer’s Hedge - A farmer owns wheat in her fields and wishes to hedge against a drop in the price she will potentially sell it for in the open market.
Show the positions involved in this hedge.
With a futures contract the
farmer locks in a price
Price per bushel
Val
ue o
f w
heat
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Financial Futures
Goal (Hedge) - To create an exactly opposite reaction in price changes, from your cash position.
Commodities - Simple because assets types are finite.
Financials - Difficult because assets types are infinite.You must attempt to approximate your position
with futures via “Hedge Ratios.”
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Financial Futures
Eurex BondGovt. German
IMMYen
IMMEuro
IMMIndex s Poor'and Standard
IMMdeposits Eurodollar
CBTbondsTreasury U.S.
CBTnotesTreasury U.S.
ExchangeFuture
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Forward Contracts
Forward Contract - Agreement to buy or sell an asset in the future at an agreed price.
Forward contracts are “custom designed” futures contracts. They have specific amounts and expiration dates to meet the buyers’ needs.
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Swaps
Swap - Arrangement by two counterparties to exchange one stream of cash flows for another.
Company Swap Dealer
Fixed rate pmt
LIBOR pmt
LIBOR pmt
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Example - Interest Rate SwapsExample - Interest Rate Swaps
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%
Swap
Aaa Corp Borrows $1mil fixed loan @ 10%
BAA Corp Borrows $1mil variable loan @ 7.5%
Aaa assumes pmts on variable loan @ 7.5%
Baa assumes pmts on fixed loan @ 10.75%
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Aaa Benefit
Pay Fix @ -10.00%
Get Fix @ +10.75%
Pay Var @ - 7.50%
Var Sav @ + 7.25%
Net Benefit + .50%
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%
Example - Interest Rate SwapsExample - Interest Rate Swaps
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Aaa Benefit Baa Benefit
Pay Fix @ -10.00% Pay Var @ - 7.50%
Get Fix @ +10.75% Get Var @ + 7.50%
Pay Var @ - 7.50% Pay Fix @ -10.75%
Var Sav @ + 7.25% Fix Sav @ +11.50%
Net Benefit + .50% Net Benefit + .75%
Available Loans Aaa Corp Baa Corp
Fixed Rate Loan 10% 11.5%
Variable Rate Loan 7.25% 7.50%
Example - Interest Rate SwapsExample - Interest Rate Swaps
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Currency Swaps
Similar to interest rate swapsSame type loan, just diff currency WHY?
example:you have an investment in JapanProject is financed with US bondsYou look for SWAP partner so you can emulate holding
Japanese bonds
Java Yahoo principalYen loan 11% 12% $ 1 mil$ loan 8% 11.1% or Y120
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Currency Swaps
example - cont
Java borrows $1mil @ 8%Yahoo borrows Y120mil @ 12%Intl. Bank arranges swapJava swaps 8% $ loan for 10.3% yen loan w/bankYahoo swaps 12% yen loan for 10.4% $ loan w/bank
total available benefit = (11.1-8) - (12-11) = 2.1%
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Currency Swaps
example - contbenefit to Java$ loan +8 - 8 = 0Yen loan +11 - 10.3 = .7 net gain +.7%
benefit to Yahoo$ loan 11.1 - 10.4 = +.7yen loan -12 + 12 = 0 net gain = .7%
benefit to bank$ loan +10.4 - 8 = +2.4yen loan - 12 + 10.3 = -1.7 net gain + .7%
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Derivative Innovations
The creative mind is the only barrier to new derivative products. Even Weather Derivatives have come into existence in recent years.
Example: A TV network may want to hedge the risk of a World Series game being rained out and thus they forego advertising income.
Who might the counterparty be to such a contract?
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Web Resources
www.cme.com www.appliederivatives.com
www.cbot.com www.derivativesreview.com
www.nymex.com www.futuresmag.com
www.euronext.com www.risk.net
www.lme.com
www.bis.org
www.isda.org
www.commoditytrader.net
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