Chapter 25 Hedging with Financial Derivatives Chapter Preview

Chapter 25 Hedging with Financial Derivatives

Chapter Preview • We examine how markets for derivatives work and how the products are used by financial managers to reduce risk. Topics include: – Hedging – Forward Markets – Financial Futures Markets – Stock Index Futures – Predicting the Fed Funds Rate Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -2

Hedging • Hedging involves engaging in a financial transaction to offset an existing position to reduces or eliminate risk. • Definitions – long position: an asset which is purchased or owned – short position: an asset which must be delivered at a future date, or an asset which is borrowed and sold, but must be replaced in the future Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -3

Forward Markets • Forward contracts are agreements by two parties to engage in a financial transaction at a future point in time. • 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 Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -4

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 2027 – 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. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -5

Hedging— Long or Short? • Quiz: Suppose you work for a business whose expects to receive $15 million from a client next year. You are worried that interest rates are going to fall next year as the US economy slows. • How would you hedge against the interest rate risk your company faces? Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -6

Hedging— Long or Short? A: You take a long position in bonds to offset your existing long position in cash—engage in a Forward Contract to buy $15 million in bonds at a fixed price. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -7

Forward Markets • Long Position – Agree to accept delivery of securities at future date subject to terms of forward contract. – Hedges by locking in future interest rate of funds coming in future, avoiding rate decreases. • Short Position – Agree to deliver securities at future date subject to terms of forward contract – Hedges by reducing price risk from increases in interest rates if holding bonds. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -8

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 3. Adverse selection and moral hazard problems. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -9

Financial Futures Markets Financial futures contracts are highly standardized forward contracts traded on organized exchanges subject to specific rules. Traded on Exchanges – Developed by Chicago Board of Trade in 1975 to solve liquidity and default problems of forward contracts. Global competition Regulated by CFTC. Commodity Futures Options Trading, Inc. home page Copyright © 2006 Pearson Addison-Wesley. All rights reserved. http: //www. cbot. com 25 -10

Financial Futures Markets • Financial Futures Contracts Specify 1. 2. 3. 4. 5. • Type of security to be traded Delivery Location Amount to be Delivered Date Price Success of FFC 1. FFC are more liquid: standardized contracts that can be traded 2. Delivery of range of securities reduces the chance of corner. 3. Mark to market daily: avoids default risk 4. Don't have to deliver: cash netting of positions Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -11

Financial Futures Markets • Delivery? 1. If the position remains open until the delivery date, then shorts must deliver and longs must accept delivery of underlying asset. 2. But before the delivery date, positions can be closed by taking the opposite position. Delivery occurs in about 3% of T-bond and T-note contracts. • Profit or Loss—note that when the price of the futures contract rises, investors with a long position gain, and short positions loose. Commodity Futures Options Trading, Inc. home page Copyright © 2006 Pearson Addison-Wesley. All rights reserved. http: //www. cbot. com 25 -12

30 Year U. S. Treasury Bonds Futures Contract Size. One U. S. Treasury bond having a face value at maturity of $100, 000 or multiple thereof. Deliverable Grades U. S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the delivery month or, if not callable, have a maturity of at least 15 years from the first day of the delivery month. The invoice price based on 6% standard. Price Quote Points ($1, 000) and thirty-seconds of a point; for example, 80 -16 equals 80 16/32 Contract Months Mar, Jun, Sep, Dec Last Trading Day Seventh business day preceding the last business day of the delivery month. Trading in expiring contracts closes at noon, Chicago time, on the last trading day. Last Delivery Day Last business day of the delivery month. Trading Hours Open Auction: 7: 20 am - 2: 00 pm, Chicago time, Monday - Friday Electronic: 6: 00 pm - 4: 00 pm, Chicago time, Sunday - Friday Trading in expiring contracts closes at noon, Chicago time, on the last trading day Ticker Symbols Open Auction: US; Electronic: ZB Daily Price Limit None Margin Information Find information on margins requirements for the 30 Year U. S. Treasury Bond Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -13

Financial Futures Markets • Trading – – – Your broker contacts floor trader who executes purchase or sale of futures contract Trades are effectively with the exchange's clearinghouse acting as a counterparty in each trade. There must be a short position for each long position. All trades require a Margin Deposit. • • • Initial Margin is set by the exchange for each contract type End of trading day settlement price on contract is determined Each open account is marked to market. If P , long position profits and short position loses. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -14

Financial Futures Markets • Example of long position in January 8 crude oil at $90 per barrel (1, 000 barrel contract). http: //www. nymex. com/WS_spec. aspx Date Settlement Price Nov. 1 $90 Nov. 2 $96. 0 Nov. 3 $86. 00 Mark to Market Deposit or Withdrawl Margin Balance $7, 763 6. 0 $6, 000 $13, 763 -10. 0 -$10, 000 $3, 763 +1, 987 $5, 750 Nov. 29 $88. 00 +2 $2, 000 $7, 750 Nov. 29 $88. 00 Close with short -7, 750 0 Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -15

Financial Futures Markets • Pricing— Arbitrage insures that settlement price on FFC and expected Spot Price should move together. At Settlement Date, price of contract = price of the underlying asset delivered. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -16

T-Bond Financial Futures Contract for delivery of $100, 000 Face Value of Treasury bond from WSJ 11/30/00. Contract specifies # of years to maturity left on the bond. Open- opening price, 101*$1000 + (25/32)*$1000 = $101, 781. 25 High/Low, Settle = final price of day. Open Interest = 151, 728*$100, 000 = $152 billion Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -17

Widely Traded Financial Futures Contracts Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -18

Widely Traded Financial Futures Contracts esoteric futures Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -19

Predicting Fed Behavior Using Fed Funds Futures • • The Chicago Board of Trade lists future contracts on the Fed Fund rates. The long position (agrees to take delivery) will receive the interest that would be paid on $5 million of fed funds held for 30 days. The short position will deliver that amount. The price of the contract is 100 minus the average Fed Funds rate during the contract month. The Fed funds contract for Dec. (Exp. Date Jan 2, 2008) is currently selling for 95. 78, so the average fed funds rate for the month of Dec. is expected to be 100 -95. 78, or 4. 22%. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -30

Fed Funds Futures Trading Unit $5 million. Price Quote 100 minus the average daily effective fed funds rate for the delivery month. Settlement The contract is cash settled against the average daily effective fed funds rate for the delivery month. Contract Months First 24 consecutive calendar months. Last Trading Day Last business day of the delivery month. Ticker Symbols Open Outcry: FF Daily Price Limit None Note that during an expiration month, the price for the current contract reflects the weighted average of two key components: 1. The realized overnight effective fed funds rates experienced to date 2. The expected effective ffs rates to the end of the month. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -31

Predicting Fed Behavior Using Fed Funds Futures • The Fed funds contract for Dec. (Exp. Date Jan 2, 2008) is currently selling for 95. 78, so the average fed funds rate for the month of Dec. is expected to be 100 -95. 78, or 4. 22%. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -32

Price of Fed Funds Futures • Futures Price during the current month: Where Daysn = number of days in the current month j = number of days passed to date. FERe is the expected Fed funds effective rate from j+1 to n. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -33

Price of Fed Funds Futures • Suppose on Nov. 9 the November contract was priced at 95. 45, implying a rate of 4. 56% = 100 - 95. 44 The price of 95. 44 reflects the average daily fed effective rate for the first 9 days of November, 4. 468, and an implied expected fed effective rate for the remaining 21 days of November of 4. 59%. Current Fed Funds Futures Rate = 4. 56% = (9/30) x 4. 468 + (21/30) x ? ? Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -34

Predicting Fed Funds Rates • Lets try to figure out the probability for a 50 basis point cut in the fed funds rate. • The current Fed Fund rate target is 4. 5%. – QUIZ: If the Fed cuts the Fed Funds rate target by 50 basis points at its next meeting (Dec. 11), what would the average fed funds rate be for the month of Dec? What probability does the Fed Funds Mkt assign to a 50 basis point cut? Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -35

Predicting Fed Funds Rates Lets try to figure out the probabilities for a 50 basis point cut. • The Current Fed Fund rate target fft = 4. 5%. • The Fed Funds futures price implies a rate of iffr = 100 - 95. 78 = 4. 22%. – The Implied Funds futures rate (iffr) is what the futures market thinks the fed funds rate will be on average for the month of Dec. • If the Fed changes the target rate after markets close on Dec. 11 -next FOMC meeting, then the first 11 days of Dec will have a rate of, ffr = fft = 4. 5%. • The last 20 days will have a rate of 4. 0% with probability p, and a rate of 4. 5% (no change) with probability (1 - p). Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -36

Predicting Fed Funds Rates So the futures market thinks the average fed funds rate for the month of May will be: iffr Where ffre = oldfft x(11/31) + ffrex(20/31) = newfft x p + oldfft x(1 - p) Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -37

Predicting Fed Funds Rates Prob is aprox = = = (ffir - oldfft)/(newfft - oldfft) (4. 22 - 4. 5)/(4. 0 - 4. 5) (-. 28)/(-. 5) 56% http: //stlouisfed. org/education/8 fc/FC-econdata. html Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -38

Chapter Summary • Hedging: the basic idea of entering into an offsetting contract to reduce or eliminate some type of risk was presented. • Forward Markets: the basic idea of contracts in this highly specialized market, as well as a simple example of eliminating risk was presented. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -39

Chapter Summary (cont. ) • Financial Futures Markets: these exchange traded markets were presented, as well as their advantages over forward contacts. • Stock Index Futures: the specific application of stock index futures was presented, exploring their ability to reduce or eliminate risk for equity portfolios. Copyright © 2006 Pearson Addison-Wesley. All rights reserved. 25 -40