Corporate Risk

Management
Session 17 & 18
 Introduction
• In March 1993, Analog Devices, manufacturer of precision
high-performance linear and mixed signal ICs, raised
$80m in capital by issuing 6.625% semi-annual coupon
bonds due March 1, 2000. Simultaneously, the firm acted
to convert half of this fixed income bond issue into a
variable-rate bond by entering into interest-rate swap.
a. Since Analog apparently wanted variable rate financing on
half of the bond issue, why didn’t it just issue $40m in
bonds with fixed coupon, and $40m with a variable
coupon
b. What would motivate a firm like Analog to convert a fixed
rate loan into a variable rate loan? What are the
dangers of doing so?
c. If you were on the owners of bonds in question, would
Analog’s swap agreement matter to you?
d. The bond indenture for these bonds spells out the terms of
the agreement between Analog and its debt-holders.
Should Analog be permitted to alter its financial
commitments by entering into the swap or should this
be prohibited by the bond indenture?
e. Who do you suppose would be the willing to be the third
 Interest Rate Swaps
Prime + Prime +
1.02% 1.0%
Floatin Floatin
g g
A n a lo g D e vice s S w a p D e a le r C om pany X YZ
6.605% 6.625%
Fixed Fixed
Prime +
6.625% Dealer 1%
Fixed makes Floatin
0.04% g

D e b t M a rke t D e b t M a rke t
 Interest Rate Swaps
• The Comparative-Advantage Argument
– It is argued that some companies have a
comparative advantage when borrowing in
fixed rate markets, where as other
companies have a comparative advantage
in floating rate markets
• Example: AAACorp has CA in fixed rate
markets whereas BBBCorp has CA in
floating rateB omarket.
rro w in g R a te s
How?
Fixed Floating

AAACorp 4.0% LIBOR+.3%

BBBCorp 5.2% LIBOR + 1.0%

 Interest Rate Swaps
• Total gain = a – b, where a is the difference between the interest
rates of the two companies in fixed rate markets, and b is the
difference in floating rate markets
• In the end, AAACorp borrow at LIBOR + 0.07% and BBB borrow at
4.97%. Gain to AAACorp is .23%, Gain to BBBCorp is 0.23%.
Swap Dealer makes 0.04%. Total Gain is 0.5%
• Why should the spreads between the rates offered to AAACorp
and BBBCorp be different in fixed and floating market? Long-
term (fixed rates) vs. short term floating rates
• Risks: For BBB Corp, rate is fixed only for six-months as the spread
in its floating rates can be revised after six months due to
changes in its credit risk
– For AAA Corp: it locks in LIBOR + 0.07% for the term of the swap but
is bears theLIBOR
risk of default by the swap LIBOR +
dealer. If AAACorp had
LIBOR
Floatin rate funds in the usual
borrowed floating way, it would not be 1%
Floatin
4% bearing this risk
g g Floatin
Fixed AAACorp Swap Dealer BBBCorp g

3.93% 3.97%
Fixed Fixed
 Interest Rate Swaps
• Ess Co has $50m of 5-year debt with a yield of 9%
compounded semiannually. This is 1.08% above the
5-yr T-note yield of 7.92%. Ess prefers floating rate
debt but its current fixed rate debt is widely held
and would be costly to repurchase. Besides, Ess’s
banker quotes a rate of LIBOR+100bps on a new
debt issue. This is higher than Ess believes is
appropriate given its credit rating. Ess is looking for
a less costly source of floating rate debt. Citigroup
agrees to a fixed for floating swap. Citi’s indication
pricing for a 5-yr fixed rate note is 33bps over the 5-
yr T-note rate (against 6-mths LIBOR flat receipts).
– Fixed rate paid by Citigroup to Ess = 7.92% + 0.33%
= 8.25%
– Floating rate paid by Ess to Citigroup = 6-mth LIBOR
– Fixed paid by Ess to its bondholders = 9%
– Net cost of floating rate funds to Ess = 6-mth LIBOR
+ 0.75%, which is below the rate quoted by Ess’s
banker
 Interest Rate Swaps
• Role of financial intermediaries
– To facilitate swap agreement between
two unknown parties
• When there is an offsetting swap with
another counterparty, Intermediary has
to honor the swap agreement in case
one of the two parties defaults
• As Market maker (no offsetting swap with
another counterparty), intermediary
must quantify and hedge the risks it is
taking. FRA and interest rate futures are
used for hedging
• A swap contract is a series of forward
contracts. How?
 Currency Swaps
• A currency is a contractual agreement to
exchange a principal amount of two different
currencies and, after a prearranged length of
time, to give back the original principal.
Interest payments in each currency are also
swapped during the life of the agreement
• America Inc (AI) has $50m of 5-yr debt at a
floating rate of 8-mth LIBOR+125bps. AI
wants fixed rate Euro debt to fund its
European operations. Citigroup agrees to pay
AI’s floating rate dollar debt in exchange for a
fixed rate Euro payment from AI. Suppose
spot exchange rate is S($/€) = 0.6667/€. Show
the transactions for this contract. Citigroup’s
indication pricing for $/€ is 6.68% sa for 5-yr
maturity against 6-mth LIBOR flat.
 Currency Swaps
What is the net cost of AI ’ s debt
post swap?
$50m
In itia l AI C itig ro u p
E xch a n g e o f
€7 5 m
Prin cip a ls
€ ( 6 . 73 % )
C a sh flo w s AI C itig ro u p
d u rin g th e life
$ 6 -m th
o f sw a p
LIB O R
€7 5 m
R e -exch a n g e AI C itig ro u p
o f Prin cip a ls
$50m
 Currency Swaps
• Expert Systems AG has €75m of 5-yr fixed rate debt with a
7.68%. ES wants floating rate dollar debt to fund its US
operations. Citigroup agrees to pay ES’s fixed rate Euro
debt in exchange for floating rate $ payment.
What is the net cost of AI ’ s debt
post swap?
€7 5 m
In itia l ES C itig ro u p
E xch a n g e o f
$50m
Prin cip a ls
$ 6 -m th LIB O R
C a sh flo w s ES C itig ro u p
d u rin g th e life
€ ( 6 . 63 % )
o f sw a p

$50m
R e -exch a n g e ES C itig ro u p
o f Prin cip a ls
€7 5 m
 Hedging with
Futures/Forwards
• Forward and futures contracts are equivalent once they are
adjusted for contract terms and liquidity
• The biggest difference between the two is that futures contracts
are settled daily while forward contract is settled at the
expiration of the contract
– Forward contracts have an inherent default risk as one side always an
incentive to default
• Futures contracts are standardized and therefore come in only
limited number of currencies, commodities, interest rates, and
expiration dates and transaction amounts. Forwards are
customized contracts
• For a corporate treasurer, the choice between forwards and
futures depends on trade-off between flexibility and liquidity
– If the size and timing of expected future cash flow is identical to that of
a futures contract, then futures market hedge will be less expensive
than a forward hedge
• Futures are used by speculators for betting as well as by hedgers
to reduce exposure to a financial price risk, such as currency,
interest rates, or commodity price risk
 Hedging with
Futures/Forwards
Payoff profiles for a forward
contractΔV ΔV

Payoff
profil
e
ΔP ΔP

Payoff
profil
e

Buyer’s Perspective Seller’s Perspective

ΔV ΔV

ΔP ΔP
Resulting
exposure

Risk profile of an oil Hedged position

user
 Hedging with
Futures/Forwards
 Use of Futures for hedging
 From the Trader’s desk
 Company A – must pay £1.0 million in Sept for imports from
UK
 Company B – will receive £3.0 million in Sept from exports to
UK
 Quotes:
 Current £/$ exchanges rate: 1.6920
 September £/$ exchanges rate: 1.6850
 Size of futures contract: £62,500


 Company A’s hedging strategy: A long position in 16 futures

contracts locks in an exchange rate of 1.6850 for the £1.0
million it will pay in Sept


 Company B’s hedging strategy: A short position in 48 futures

contracts locks in an exchange rate of 1.6850 for the £3.0
million that it will receive in Sept
 Hedging Currency Risk
• Hedging currency risk with forward/futures contract
• BO is a US firm that buys Japanese VCRs and distributes
them to a chain of European Retail stores. BO has
promised to pay its Japanese supplier ¥12,500,000 in
three months on March 23 (which happens to be the
expiration date of CME futures contract). The European
retailer has promised to pay BO €250,000 on the same
date. How does BO hedge its foreign currency risk?
– BUY ¥12,500,000 futures
– SELL €250,000 futures
– Fut0,T $/€ = $0.4/€, Fut0,T $/¥ = $0.0080 /¥
• Buying Yen futures is equivalent to selling $100,000
• Selling Euro futures is equivalent to buying $100,000
• This will result in perfect hedge as currency match and
maturity is same as the delivery/receipt of Yen/Euro is same
the maturity of futures contract
• Can BO use forward contracts instead of futures contracts
here?
– Cost of forward contract may be higher
– Default risk inherent in forward contracts
 Hedging Currency Risk
• In previous example, suppose BO can trade ¥/€ futures
contract.
– Arbitrage will ensure rate are in equilibrium.
¥/€
• Fut0,T = ¥50/€
– Contract size is €125,000, implying each contract is
worth ¥6,250,000
– BO sells two ¥/€ futures contracts to hedge its
currency risk. This is an example of cross-hedge.
• BO should shop around in order to hedge currency
exposure effectively and at the least cost
• Commission charge on two cross-rate futures contract will
be less than the commissions charged on three futures
contract (one $/¥ and two $/€)
• BO could consider trading on Tokyo Futures exchange. If BO
has a Japanese subsidiary, a cross-rate hedge on the
Tokyo Exchange may be less expensive than multiple
contracts on the CME
• However, it is likely that the size and timing of ¥/€ futures
contract may not match the size and timing of BO’s
underlying exposure
 Hedging Currency Risk – Delta
Hedge
• In a futures hedge, the underlying position (in currency,
commodity) is settled in the spot market and the futures
position is settled at the futures position
• Futures prices converge to spot prices at expiration.
However, prior to expiration, there is a risk that nominal
interest rates will change in one or both currencies
• The relative interest rate differential is often approx by the
simple difference in nominal interest rates (id-if). This
difference is called the basis
• The risk of unexpected change in the relationship between
futures and spot prices (due to unexpected change in
basis is) is called basis risk
• When there is a maturity mismatch between the futures
contract and the underlying currency exposure, basis risk
makes the futures hedge riskier
• In a perfect hedge, hedging ratio is -1.0, but in a hedge with
maturity mismatch, hedging ratio is give by –β, where β
is the regression coefficient of change in futures prices
relative to changes in spot prices.
 Basis risk - example
• Today is March 13. Ready Mac Co has a
€10m obligation coming up in October
26. The nearest CME $/€ futures
mature on Sept 11 and Dec 16.
• There is a maturity mismatch
– Days to obligation closure: 227 days
– Days to Maturity of Dec 16 futures: 278
days
– Ready Mac buys Dec 16 futures and will
close the position on Sept 11.
• Current spot price S0 $/€ = $0.6/€
• F0,t $/€ = S0 $/€ [(1+i$)/(1+i€)]t
 Basis Risk - Example
• A maturity mismatch in Metallgesellschaft’s Oil futures
hedge
– Its subsidiary MGRM has long-term (10yr) supply
contracts to supply US retailers with gasoline,
heating oil and jet fuel Contracts were of three
types: fixed rate, variable rate, and guaranteed
margin
– To hedge the risk of these delivery obligations, MGRM
formed a rolling stack of long positions in crude oil
futures contracts of the nearest maturity
• Each month, the long position was rolled over into the
next month’s contract. MGRM used a one-to-one
hedging strategy in which long-term obligations
were hedged dollar-to-dollar with position in crude
oil futures
– Mismatch between long-term delivery obligations
and short-term futures positions created problems
for MGRM
• Fluctuations in the price of near-term futures contracts
resulted in large fluctuations in the short-term cash
flows
Hedging with Futures
Hedge Underlying Price Risk
Exact Match Mismatch
Mat Exact Perfect hedge Cross-hedge
urit Match
y Mismatch Delta hedge Delta cross-
hedge
 Hedging with Futures
• For the following scenarios, describe a
hedging strategy with futures contracts
that might be considered
– a public utility that uses oil is concerned
about rising costs
– A candy manufacturer is concerned about
rising costs
– A corn farmer fears that this year’s harvest
will be at record high levels across country
– A stock mutual fund invests in large, blue-
chip stocks and is concerned about a
decline in the stock market
– A US importer of Swiss army knives will pay
for its order in six months in Euros
– A bank derives all its income from long-
term, fixed rate residential mortgages
 Hedging with Option
Contracts
ΔV ΔV

Payoff
profil Payoff
e profil
ΔP e ΔP

Buying a Call Buying a Put

ΔV ΔV

ΔP ΔP

Payoff Payoff
profil profil
e e

Selling a Call Selling a Put

 Hedging with Option
ΔV
Contracts Put ΔV
Option
Payoff
Risk Hedged
Profil Profil
e e
ΔP ΔP

Origin
al
profil
e

Un-hedged Risk Hedged Risk Profile

Profile
Key differences between an option contract and a forward/futures contract
With a forward/futures contract, both parties are obligated to transact.
With an option contract, transaction occurs only if the owner of the
option chooses to exercise it
With an option hedge, the payoff profile is asymmetric. While, a
forward/futures hedge has a symmetric payoff profile
While no money changes hands when a forward contract is created, the buyer
of an option contract gains a valuable right and must pay the seller
for that right. The price of the option is called option premium


 Hedging with Option
Contracts
• What is the underlying asset or deliverable instrument
of an options contract on currency, commodity or
interest rates?
– Options that are typically traded on commodities,
currencies and interest rates are actually options
on futures contracts (futures options)
– Example: When a futures call option on wheat is
exercised, the owner receives two things
• The first is a nearest futures contract on wheat at the
current futures price, which can be immediately
closed at no cost
• The second thing is the difference between the strike
price on the option and current futures price, which
is paid in cash
– Typically, corporate exposed to financial price risk
value the right to exercise an option and do not
want the obligation from writing options contract.
Investment and commercial banks are typically the
writers of options contract.

 Hedging with Option
Contracts
• Consider a CME call option on Euro with an
exercise price of $0.64/€ and expiring in
December and selling at a price of $0.012/ €.
Determine the option payoff at futures price
of $0.652/€, $0.625/€ and $0.664/€
–
Profit at
expiratio
n, $/€

Fut $/
€
 Hedging with Option
Contracts
• To hedge interest rate risk, there are options available
on treasury bond futures.
• Suppose a corporation wants to protect itself against
an increase in interest rates using options. What
should it go?
– Corporate should buy an options that increases in
value as interest rates go up
• By buying a put option on a bond. Why?
• By buying a call option on interest rates
– How do you interpret call provision in bonds?
• By buying interest rate caps (call option on interest
rate) from a bank
– If loan payments rise above an agreed upon ceiling,
then the bank will pay the difference between the
actual payment and the ceiling to the firm in cash
• Suppose the firm has a floating rate loan and would
like to have the right to convert it into a fixed rate
loan in the future. What should it do?
– Buy an option on a swap or a swaption
 Hedging with Option
Contracts
• Suppose a corporate has a cash flow
in pound sterling expected in 3
months. How can it hedge its $ per
pound risk by using options to get a
flat risk profile
– Long call ($/£), short put ($/£) ?OR
– Short call ($/£), long put ($/£) ?
Appendix
 Hedging using derivatives
 Use of Options for Hedging
 From the Trader’s desk
 An investor owns 500 shares on Company X
and wants protection against possible
decline in the share price over the next two
months
 Quotes:
 Current Stock X price: Rs 102
 Stock X October 100 put: Rs4


 The investor’s strategy

 The investor buys 5 put options contracts for a
total of Rs2000
 Trading Strategies
• Strategies Involving a Single Option
and a Stock
– Long stock, short call
– Short Stock, long call
– Long Stock, long put
– Short stock, short put
 Trading Strategies
• Spreads: Positions in two or more
options of the same type
– Bull Spread: Long call option with
strike price X1 and short call option
with strike price X2, where X2 > X1;
Requires initial investment
Stock Price Payoff from Payoff from Total Payoff
ST ≥–X2
Range Long Call
(ST – X1)
Short
-(ST –Call
X2) X2 – X1
option option
ST ≤ X1 0 0 0
X1 < ST < X2 (ST – X1) 0 ST – X1
 Spreads
• Bear Spread
– Long call option with strike price X2
and short call option with strike
price X1, where X2 > X1; Requires
initial investment; Involves initial
Stock Price Payoff from Payoff from Total Payoff
Range
cash Long
inflow
Call Short Call
ST ≥ X2 (ST – X2) -(ST – X1) – (X2 – X1)
option option
ST ≤ X1 0 0 0
X1 < ST < X2 0 -(ST – X1) –(ST – X1)
 Spreads
 Butterfly Spreads
– Long a call option with strike price X1,
long a call option with strike price X3,
and short two call options with strike
price X , where X > X1, and X2 = (X1
Stock Price Payoff 2 Payoff 3 Payoff Total
Range
S T < X1
+ 0X
from
3)/2
‘X1’ 0from ‘X2’ 0from ‘X3’ 0Payoff
X1 < ST < long
(ST –Call
X1) 0Short Call 0long Call ST – X1
option
X2 < ST < (ST – X1) optionT – 0option
-2*(S X3 – ST
S
XT3 > X3 (ST – X1) -2*(S
X2) T – (ST – X3) 0
X2)
 Combinations
 Combinations involve taking a position
in both calls and puts on the same
stock
– Straddle: Long call and long put with the
same strike price and expiration date
– Appropriate when investor is expecting a
large price movement but doesn’t know
the direction
Stock Price Payoff from Payoff from Total Payoff
Range
ST > X Long Call
(ST – X) Long
0 put (ST – X)
option option
ST ≤ X 0 (X – ST) (X – ST)