Chapter 25

Hedging with
Financial
Derivatives
 Chapter Preview

Starting in the 1970s, the world became a

riskier place for financial institutions.
Interest rate and exchange rate volatility
increased, as did the stock and bond
markets. Financial innovation helped with
the development of derivatives. But if
improperly used, derivatives can
dramatically increase the risk institutions
face.
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 Chapter Preview

• In this chapter, we look at the most important

derivatives that managers of financial institution
use to manage risk. We examine how the
markets for these derivatives work and how the
products are used by financial managers to
reduce risk. Topics include:
– Hedging
– Forward Markets
– Financial Futures Markets

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 Chapter Preview (cont.)

– Stock Index Futures

– Options
– Interest-Rate Swaps
– Credit Derivatives

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 Hedging

• Hedging involves engaging in a financial

transaction that reduces or eliminates risk.
• Definitions
– long position: an asset which is purchased
or owned
– short position: an asset which must be
delivered to a third party as a future date, or an
asset which is borrowed and sold, but must be
replaced in the future

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 Hedging

• Hedging risk involves engaging in a

financial transaction that offsets a long
position by taking an additional short
position, or offsets a short position by
taking an additional long position.
• We will examine how this is specifically
accomplished in different financial markets.

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 Forward Markets

• Forward contracts are agreements by two

parties to engage in a financial transaction at a
future point in time. Although the contract can be
written however the parties want, the contract
usually includes:
– The exact assets to be delivered by one party,
including the location of delivery
– The price paid for the assets by the other party
– The date when the assets and cash will be exchanged

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 Forward Markets

• An Example of an Interest-Rate Contract

– First National Bank agrees to deliver $5 million
in face value of 6% Treasury bonds maturing
in 2023
– Rock Solid Insurance Company agrees to pay
$5 million for the bonds
– FNB and Rock Solid agree to complete the
transaction one year from today at the FNB
headquarters in town

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 Forward Markets

• Long Position
– Agree to buy securities at future date
– Hedges by locking in future interest rate of funds
coming in future, avoiding rate decreases

• Short Position
– Agree to sell securities at future date
– Hedges by reducing price risk from increases in
interest rates if holding bonds

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 Forward Markets

• Pros
1. Flexible

• Cons
1. Lack of liquidity: hard to find a counter-party
and thin or non-existent secondary market
2. Subject to default risk—requires information
to screen good from bad risk

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 Financial Futures Markets

• Financial futures contracts are similar to

forward contracts in that they are an
agreement by two parties to engage in a
financial transaction at a future point in
time. However, they differ from forward
contracts in several significant ways.

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 Financial Futures Markets

• Success of Futures Over Forwards

1. Futures are more liquid: standardized
contracts that can be traded
2. Delivery of range of securities reduces the
chance that a trader can corner the market
3. Mark to market daily: avoids default risk
4. Don't have to deliver: cash netting
of positions

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 Example: Hedging Interest Rate Risk

• A manager has a long position in Treasury

bonds. She wishes to hedge against
interest rate increases, and uses T-bond
futures to do this:
– Her portfolio is worth $5,000,000
– Futures contracts have an underlying value of
$100,000, so she must short 50 contracts.

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 Example: Hedging Interest Rate Risk

– As interest rates increase over the next 12

months, the value of the bond portfolio drops
by almost $1,000,000.
– However, the T-bond contract also dropped
almost $1,000,000 in value, and the short
position means the contact pays off that
amount.
– Losses in the spot T-bond market are offset by
gains in the T-bond futures market.

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 Financial Futures Markets

• The previous example is a micro hedge –

hedging the value of a specific asset.
Macro hedges involve hedging, for
example, the entire value of a portfolio, or
general prices for production inputs.

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Following the News

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Widely Traded Financial
Futures Contracts
 Hedging FX Risk

• Example: A manufacturer expects to be

paid 10 million euros in two months for the
sale of equipment in Europe. Currently, 1
euro = $1, and the manufacturer would like
to lock-in that exchange rate.

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 Hedging FX Risk

• The manufacturer can use the FX futures

market to accomplish this:
1. The manufacturer sells 10 million euros of futures
contracts. Assuming that 1 contract is for $125,000
in euros, the manufacturer takes as short position in
80 contracts.
2. The exchange will require the manufacturer to
deposit cash into a margin account. For example,
the exchange may require $1,000 per contract, or
$80,000.

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 Hedging FX Risk

3. As the exchange rate fluctuates during the

two months, the value of the margin account
will fluctuate. If the value in the margin
account falls too low, additional funds may
be required (margin call). This is how the
market is marked to market. If additional
funds are not deposited when required, the
position will be closed by the exchange.

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 Hedging FX Risk

4. Assume that actual exchange rate is 1 euro = $0.96

at the end of the two months. The manufacturer
receives the 10 million euros and exchanges them in
the spot market for $9,600,000.
5. The manufacturer also closes the margin account,
which has $480,000 in it—$400,000 for the changes
in exchange rates plus the original $80,000 required
by the exchange (assumes no margin calls).
6. In the end, the manufacturer has the $10,000,000
desired from the sale.

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 Stock Index Futures

• Financial institution managers, particularly

those that manage mutual funds, pension
funds, and insurance companies, also need
to assess their stock market risk, the risk
that occurs due to fluctuations in equity
market prices.
• One instrument to hedge this risk is stock
index futures.

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 Stock Index Futures

• Stock index futures are a contract to buy or sell

a particular stock index, starting at a given level.
Contracts exist for most major indexes, including
the S&P 500, Dow Jones Industrials, Russell
2000, Hang Shen Index, Huseng 300 Index, etc.
• The “best” stock futures contract to use is
generally determined by the highest correlation
between returns to a portfolio and returns to a
particular index.

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 Hedging with Stock Index Futures

• Example: Rock Solid has a stock portfolio

worth $100 million, which tracks closely
with the S&P 500. The portfolio manager
fears that a decline is coming and wants to
completely hedge the value of the portfolio
over the next year. If the S&P is currently
at 1,000, how is this accomplished?

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 Hedging with Stock Index Futures

• Value of the S&P 500 Futures Contract =

250  index
– currently 250 x 1,000 = $250,000
• To hedge $100 million of stocks that move
1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
– sell $100 million of index futures =
400 contracts

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 Hedging with Stock Index Futures

• Suppose after the year, the S&P 500 is at 900

and the portfolio is worth $90 million.
– futures position is up $10 million

• If instead, the S&P 500 is at 1100 and the

portfolio is worth $110 million.
– futures position is down $10 million

• Either way, net position is $100 million

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 Hedging with Stock Index Futures

• Note that the portfolio is protected from

downside risk, the risk that the value in the
portfolio will fall. However, to accomplish this,
the manager has also eliminated any
upside potential.
• Now we will examine a hedging strategy that
protects against downside risk, but does not
sacrifice the upside. Of course, this comes at
a price!

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 Options

• Options Contract
– Right to buy (call option) or sell (put option) an
instrument at the exercise (strike) price up until
expiration date (American) or on expiration
date (European).

• Options are available on a number of

financial instruments, including individual
stocks, stock indexes, etc.

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 Options

• Hedging with Options

– Buy same number of put option contracts as
would sell of futures
– Disadvantage: pay premium
– Advantage: protected if i increases and price
declines

• if i decreases and price increases

– no losses on option
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Options
 Profit Profiles for Calls

Profit Call Holder

Call Writer

Stock Price
 Profit Profiles for Puts

Profits

Put Writer
0

Put Holder

Stock Price
 Protective Put Profit

Profit Stock
Protective
Put Portfolio

-P ST
 Covered Call Profit

Profit Stock

Covered
Call
Portfolio
-P ST
 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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 Hedging with Options

• Example: Rock Solid has a stock portfolio

worth $100 million, which tracks closely
with the S&P 500. The portfolio manager
fears that a decline is coming and want to
completely hedge the value of the portfolio
against any downside risk. If the S&P is
currently at 1,000, how is this
accomplished?

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 Hedging with Options

• Value of the S&P 500 Option Contract =

100  index
– currently 100 x 1,000 = $100,000

• To hedge $100 million of stocks that move

1 for 1 (perfect correlation) with S&P
currently selling at 1000, you would:
– buy $100 million of S&P put options =
1,000 contracts

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 Hedging with Options

• The premium would depend on the strike price.

For example, a strike price of 950 might have a
premium of $200 / contract, while a strike price of
900 might have a strike price of only $100.
• Let’s assume Rock Solid chooses a strike price of
950. Then Rock Solid must pay $200,000 for the
position. This is non-refundable and comes out
of the portfolio value (now only $99.8 million).

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 Hedging with Options

• Suppose after the year, the S&P 500 is at 900

and the portfolio is worth $89.8 million.
– options position is up $5 million (since 950 strike price)
– in net, portfolio is worth $94.8 million

• If instead, the S&P 500 is at 1100 and the

portfolio is worth $109.8 million.
– options position expires worthless, and portfolio is
worth $109.8 million

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 Hedging with Options

• Note that the portfolio is protected from any

downside risk (the risk that the value in the
portfolio will fall ) in excess of $5 million.
However, to accomplish this, the manager
has to pay a premium upfront of $200,000.

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