CH 33

Chapter - 33
Derivatives for Managing

Financial Risk
2 Financial Management, Ninth Edition I M Pandey
Vikas Publishing House Pvt. Ltd.
Chapter Objectives
Understand the reasons for hedging.
Show how options can be used to hedge risk.
Explain forward and futures contracts.
Illustrate the use of futures and forward
contracts for hedging risk.
Discuss use of swaps to change the risk of
interest rates and currencies.
Derivatives and Risk Hedging
A derivative is a financial instrument whose
pay-offs is derived from some other asset
which is called as an underlying asset.
There are a large number of simple derivatives
like futures or forward contracts or swaps.
Options are more complicated derivatives.
Derivatives are tools to reduce a firms risk
exposure. Hedging is the term used for
reducing risk by using derivatives.
Advantages of Risk Management
through Hedging
Debt capacity enhancement
Increased focus on operations
Isolating managerial performance
Risk Hedging with Options
An option is a right to buy or sell an asset at a
specified exercise price at a specified period of
time.
Foreign currency option is a handy method of
reducing foreign exchange risk. Similarly,
options on interest rates and commodities are
quite popular with managers to reduce risk.
Many options trade on option exchanges.
However, in practice, banks and companies
strike private option deals.
Example
Suppose ONGC sells oil to IPCL. ONGC wants to protect
itself from a potential fall in oil prices. It should buy a put
option a right to sell oil at a specified exercise price at a
specified time. ONGC will be able to protect itself from
falling prices and at the same time benefit from increase in
the oil prices.
ONGC buys the put option with the Rs 25,000 exercise
price at a premium of Rs 50 per barrel. If the price of oil on
the day option expires is less than the exercise price,
ONGC will exercise the option since it will fetch the locked
in price of Rs 25,000 per barrel. On the other hand, if the oil
price is more than the exercise price, it will allow the option
to lapse as it can get sell the oil at a higher price. In both
situations there is a cost in the form of option premium
involved.
Example
A goldsmith plans to purchase 1,000 troy ounces of gold in
three months. He suspects fluctuations in the gold prices.
The price could be $320, $340 or $360 an ounce. The
goldsmith is thinking of buying a 3-month call option on
1,000 ounces of gold with an exercise price of $340. The
option will cost $4 per ounce. The goldsmith would exercise
the call option when the gold price is more than the exercise
price, otherwise he would allow it to lapse.

Gold Price, Rupees per ounce
$320 $340 $360
Cost of 1,000 ounces 320,000 340,000 360,000
Less: payoff on call option 0 0 20,000
Plus: option premium 4,000 4,000 4,000
324,000 344,000 344,000

Forward Contracts
A forward contract is an agreement between two
parties to exchange an asset for cash at a
predetermined future date for a price that is specified
today.
In case of a forward contract, both the buyer and the
seller are bound by the contract while Under an option,
the buyer has a right to decide whether or not she would
exercise the option.
Forward contracts are flexible. They are tailor-made to
suit the needs of the buyers and sellers. Foreign
currencies forwards have the largest trading.
Example
An Indian company has ordered machinery from USA.
The price of $ 500,000 is payable after six months. The
current exchange rate is Rs45.75/$. At the current
exchange rate, the company would need: 45.75 500,000
= Rs 22,875,000. But the company anticipates
depreciation of Indian rupee over time. The cost to the
company in Indian rupees will increase if rupee
depreciates when payment is made after six months.
What should the company?
The company can lock in the exchange rate by entering
into a forward contract and forget about any fluctuation in
the exchange rate. Suppose the six-month forward
exchange rate is Rs45.95. The company can buy dollars
forward. At the time of making payment, it will exchange
Rs 22,975,000 for buying $500,000.
Futures Contracts
Future contracts are forwards contracts traded on organised
exchanges in standardised contract size. For example, the
standard contract size for barley in the barley international
exchange is 20 metric ton.
The short hedge is a common occurrence in business, and
it takes place whenever a firm or an individual is holding
goods or commodities (or any other asset) or is expecting to
receive goods or commodities
Generally, a long hedge occurs when a person or the firm is
committed to sell at a fixed price.
Unlike options but like forward contracts, future contracts
are obligations; on the due date the seller (farmer) has to
deliver barley to the buyer (miller) and the buyer will pay the
seller the agreed price. In the futures contracts, like in the
forward contracts, one partly would lose and another will
gain.
Example
A coal mining company is
concerned about short-term
volatility in its revenues. Coal
currently sells for Rs 7,000
per ton. But the price could
fall as low as Rs 6,500 per
ton or as high as Rs 7,400
per ton. The company will
supply about 5,000 tons to
the market next month. What
are the consequences if the
company does not hedge?
What is the cost to the
company if it enters into a
futures contract to deliver
5,000 tons of coal at an
agreed price of Rs 7,050 per
ton next month?
H e d g i n g
R i s k :

F u t u r e s
p r i c e
7 , 0 5 0 7 , 0 5 0 7 , 0 5 0
S p o t p r i c e 7 , 4 0 0 7 , 0 0 0 6 , 5 0 0
P r o f i t / l o s s - 3 5 0 + 5 0 + 5 5 0

Financial Futures
Financial futures, like the commodity
futures, are contracts to buy or sell financial
assets at a future date at a specified price.
Financial futures, introduced for the first time
in 1972 in USA, have become very popular.
Now the trading in financial futures far
exceeds trading in commodity futures.
Futures Contracts Vs. Forward
Contracts
Organised futures exchanges
Standardised contracts
Margin
Marked to market
Delivery
Futures and Spot Prices of Financial
Futures
The price of an asset for immediate delivery is
known as the spot price.
Under the futures contract, there will be no out
go of cash and the buyer has an opportunity of
earning interest on the purchase price. But,
since the buyer will not hold the asset, he will
lose the opportunity of earning dividends.
Futures price Spot price (1 ) dividend foregone
Future price Dividend foregone
Spot price
(1 ) (1 )
f
f f
t
t t
r
r r
= +
= +
+ +
Spot and Future Prices of
Commodity Futures
The spot and futures prices relationship in case
of commodities futures is given as follows:
Future price Storage costs Convenience yield
Spot price
(1 ) (1 ) (1 )
Future price Storage costs Convenience yield
Spot price
(1 ) (1 ) (1 )
t t t
f f f
t t t
f f f
r r r
r r r
= +
+ + +
| |
= +
|
|
+ + +
\ .
Example
Suppose the spot price for wheat was $2.85 per
bushel in September 2004. The one-year
futures price was $3.38 per bushel. The interest
rate is 6 per cent. What is the net convenience
yield?

Net Convenience Yield as a percentage of spot
price is: 0.34/2.85 = 0.119 or 11.9 per cent.
1
3.38
2.85 PV(storage costs convenience yield)
(1.06)
PV(NCY) = 3.19 2.85 $ 0.34
= +
=
Swaps
A swap is an agreement between two parties,
called counterparties, to trade cash flows over
a period of time.
Two most popular swaps are currency swaps
and interest-rate swaps.
Currency swap involves an exchange of cash
payments in one currency for cash payments in
another currency.
The interest rate swap allows a company to
borrow capital at fixed (or floating rate) and
exchange its interest payments with interest
payments at floating rate (or fixed rate).
Example
Mr. John is the portfolio manager in Osram Mutual Fund
Company. He has a debt fund that has invested Rs 200
million in long-term corporate debentures. He wants to
convert the holding into a synthetic floating-rate
portfolio. The portfolio pays 9 per cent fixed return.
Assume that a swap dealer offers 9 per cent fixed for
MIBOR (Mumbai Inter Borrowing Rate). What should
Mr. John do?
Mr. John should swap receiving MIBOR on a notional
principal of Rs 200 million in exchange for payment at 9
per cent fixed rate. The cash flows of portfolio will
change with MIBOR as shown below:
Example
MIBOR Rate
8.50% 9.00% 9.50%
Fixed-rate portfolio return
(9% Rs 200 million)
18 18 18
+ Net cash flow on swap
[(MIBOR 0.09) Rs 200 million]
1 1
Net payment 17 18 19
Use of Derivatives
In many countries, particularly the developing countries,
no derivatives or very few types of derivatives are
available.
Even in developed economies where derivatives
markets are well developed, all companies do not make
full use of derivatives. Most surveys on the use of
derivatives reveal that derivatives are popular among
the large listed companies in US. About the half of
publicly traded firms uses one or the other form of
derivatives. Among the companies using derivatives,
the most widely used derivatives are the interest rate
derivatives and the foreign exchange rate derivatives.
Use of Derivatives
The objective of firms using derivatives is to
reduce the cash flow volatility and thus, to
diminish the financial distress costs. This is
consistent with the theory of risk management
through derivatives. Some firms use derivatives
not for for the purpose of hedging risk rather to
speculate about futures prices.

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Chapter - 33

Derivatives for Managing

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