CORPORATE FINANCIAL THEORY Lecture 11 Hedging Futures Today

CORPORATE FINANCIAL THEORY Lecture 11

Hedging & Futures Today We will return to Capital Budgeting & Financing. We will discuss how to reduce risk. Companies have risk Manufacturing Risk - variable costs Financial Risk - Interest rate changes Goal - Eliminate risk HOW? Hedging & Futures Contracts

Example – Cereal Production Kellogg’s produces cereal. A major input and variable cost is sugar. The price of a box of cereal is inflexible (i. e. it has an elastic demand function). Kellogg’s is naturally “short” in sugar “short” = a requirement to buy the commodity in the future. Profit Scenario for Kellogg’s Revenue -costs This is variable Profits

Example – Cereal Production (continued) • Natural profit / loss position • To hedge their natural position, Kellogg’s will enter into a long futures / forward contract Profit Short sugar Long Futures / Forward Contract Asset Price Loss

Example – Cereal Production (continued) NET POSITION Profit Asset Price Loss

Example – Cereal Production (continued) Farmer’s view Profit Scenario for Farmer Revenue This is variable -costs Profit Loss Short Forward / futures Long sugar Asset Price

Example – Cereal Production (continued) Together Long Hedger Short Hedger Natural position: Short sugar Natural position: Long sugar Risk: Purchase price of sugar Risk: Sales price of sugar Hedge: Long contract Hedge: Short contract

Types of Forwards / Futures Commodity Futures -Sugar -Corn -OJ -Wheat -Soy beans -Pork bellies Financial Futures -Tbills -Yen -GNMA -Stocks -Eurodollars Index Futures -S&P 500 -Value Line Index -Vanguard Index

Futures/Forward Contracts Types of Contracts 1 - Spot Contract - A K for immediate sale & delivery of an asset. 2 - Forward Contract - A K between two people for the delivery of an asset at a negotiated price on a set date in the future. 3 - Futures Contract - A K similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract.

Futures Contract Concepts Not an actual sale Always a winner & a loser (unlike stocks) K are “settled” every day. (Marked to Market) Hedge - K used to eliminate risk by locking in prices Speculation - K used to gamble Margin - not a sale - post partial amount

Example: Speculation You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops. 17 cents per pound ($. 0017) what is total change in your position? 30, 000 lbs x $. 0017 loss x 10 Ks = $510. 00 loss 50. 63 -$510 50. 80 cents per lbs Since you must settle your account every day, you must give your broker $510. 00

Example: Hedge You are an Illinois farmer. You planted 100 acres of wheat this week, and plan on harvesting 20, 000 bushels in March. If today’s futures wheat price is $1. 56 per bushel, and you would like to lock in that price, what would you do? Since you are long in Wheat, you will need to go short on March wheat. Since 1 contract= 5, 000 bushels, you should short four contracts today and close your position in March.

Example: Commodity Hedge In June, farmer John Smith expects to harvest 10, 000 bushels of corn during the month of August. In June, the September corn futures are selling for $2. 94 per bushel (1 K = 5, 000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price drops to $2. 80. Revenue from Crop: 10, 000 x 2. 80 28, 000 June: Short 2 K @ 2. 94 = 29, 400 Sept: Long 2 K @ 2. 80 = 28, 000 Gain on Position---------------Total Revenue . 1, 400 $ 29, 400

Example: Commodity Hedge In June, farmer John Smith expects to harvest 10, 000 bushels of corn during the month of August. In June, the September corn futures are selling for $2. 94 per bushel (1 K = 5, 000 bushels). Farmer Smith wishes to lock in this price. Show the transactions if the Sept spot price rises to $3. 05. Revenue from Crop: 10, 000 x 3. 05 30, 500 June: Short 2 K @ 2. 94 = 29, 400 Sept: Long 2 K @ 3. 05 = 30, 500 Gain on Position---------------Total Revenue . -1, 100 $ 29, 400

Margin The amount (percentage) of a Futures Contract Value that must be on deposit with a broker. Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin. CME margin requirements are 15% Thus, you can control $100, 000 of assets with only $15, 000.

Example: Margin Example – Commodity Speculation: No Margin You think you know everything there is to know about pork bellies (bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38, 000 lbs. Today, you decide to short three May Ks @ 44. 00 cents per lbs. In Feb, the price rises to 48. 5 cents and you decide to close your position. What is your gain/loss? Nov: Short 3 May K (. 4400 x 38, 000 x 3 ) = + 50, 160 Feb: Long 3 May K (. 4850 x 38, 000 x 3 ) = - 55, 290 Loss of 10. 23 % = - 5, 130

Example: Margin Example –Commodity Speculation: With Margin You think you know everything there is to know about pork bellies (bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38, 000 lbs. Today, you decide to short three May Ks @ 44. 00 cents per lbs. In Feb, the price rises to 48. 5 cents and you decide to close your position. What is your gain/loss? Nov: Short 3 May K (. 4400 x 38, 000 x 3 ) = + 50, 160 Feb: Long 3 May K (. 4850 x 38, 000 x 3 ) = - 55, 290 Loss = Loss ------ Margin = 5130 ---------- 50160 x. 15 = 5130 ------ = 7524 - 5, 130 68% loss

Commodity Trading Places Short and Long Trades

Financial Futures Goal (Hedge) - To create an exactly opposite reaction in price changes, from your cash position. Commodities - Simple because assets types are standard. Financials - Difficult because assets types are infinite. - You must attempt to approximate your position with futures via “Hedge Ratios. ”

Ex - Financial Futures Example - Hedge Bond Position Futures Position Nov Long $1, 000 Short 1 K @$970 March Sell @ $930 Long 1 K @$900 loss $70 Net position = $ 0 gain $ 70

Price Bond Prices & Yields Yield

Bond Price Sensitivity Bond A YTM = 4. 00% Maturity = 8 years Coupon = 6% or $60 Par Value = $1, 000 Price = $1, 134. 65 Bond B YTM = 3. 50% Maturity = 5 years Coupon = 7% or $70 Par Value = $1, 000 Price = $1, 158. 03

Bond Price Sensitivity Bond B Bond A YTM = 4. 75% Maturity = 8 years Coupon = 6% or $60 Par Value = $1, 000 New Price= $1, 081. 61 YTM = 4. 25% Maturity = 5 years Coupon = 7% or $70 Par Value = $1, 000 New Price =$1, 121. 57 Price dropped by 3. 25 % Price dropped by 4. 67 % Yields increased 0. 75%. . . prices dropped differently

Ex - Financial Futures Example - Hedge Reality Bond Position Futures Position Nov Long $1, 000 Short 1 K @$970 March Sell @ $930 Long 1 K @$920 loss $70 gain $ 50 Net position = $ 20 loss

Ex - Financial Futures You are long in $1 mil of bonds (15 yr 8. 3125% bonds) The current YTM is 10. 45% and the current price is 82 -17. You want to cash out now, but your accountant wants to defer the taxes until next year. The March Bond K is selling for 80 -09. Since each K is $100, 000, you need to short 10 March Ks. In March you cash out with the Bond price = 70 -26 and the K price = 66 -29. What is the gain/loss?

Ex - Financial Futures You are long in $1 mil of bonds (15 yr 8. 3125% bonds) The current YTM is 10. 45% and the current price is 82 -17. You want to cash out now, but your accountant wants to defer the taxes until next year. The March Bond K is selling for 80 -09. Since each K is $100, 000, you need to short 10 March Ks. In March you cash out with the Bond price = 7026 and the K price = 66 -29. What is the gain/loss? Cash Futures Basis Nov $825, 312 $802, 812 + (2 -8) March $708, 125 $669, 062 + (3 -29) Gain/Loss ($117, 187) $133, 750 + (1 -21) Net Gain = $16, 563 (= 1 -21 x $1 mil)

Financial Futures The art in Financial futures is finding the exact number of contracts to make the net gain/loss = $ 0. This is called the Hedge Ratio $ Face Value Cash # of Ks = ----------------- X Hedge Ratio $ Face Value of Futures K HR Goal - Find the # of Ks that will perfectly offset cash position.

Hedge Ratio Determination 1 - The Duration Model 2 - Naive Hedging Model 3 - Conversion Factor Model 4 - Basis Point Model 5 - Regression Model 6 - Yield Forecast Model

Swaps An agreement between two firms in which each firm agrees to exchange (or Swap) the “interest rate characteristics” of two different financial instruments of identical principal. Types Interest Rate Swaps Currency Swaps