FIN4320_Lecture_16_Financial_Risk_Management(53p)

FIN4320_Lecture_16_Financial_Risk_Management(53p) - F...

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Unformatted text preview: F inancial Risk M anagement P ur pose of D er ivative I nstr uments H edge Against U ncer tainty H edging Ver sus Speculating Speculating H edging • Reduce or Eliminate Risk Speculating • Assuming Additional Risk T ypes of Risk Pr ice Risk I nter est Rate Risk F or eign Exchange Risk M ar k et Risk O bjectives of F inancial Risk M anagement R isk D eter mine Risk Pr ofile Set Basic Goals I dentify and M easur e the L evel of Exposur e E xposur M anage Exposur e M onitor Exposur e F utur es Ver sus F or w ar d Contr acts C ontr B oth Ar e Obligations to D eliver Both ( Receive) a Specified Amount of a Specified Good on a Specified D ate at a Specified Place F utur es Ar e Standar dized Standar d Contr act Size Standar d D eliver y D ate Standar d D eliver y Place Standar d Gr ade Exchange T r aded G uar anty of Contr act Guar Per for mance P er M ar k ed to M ar k et F utur es M ar k ets F utur es Ver sus Cash Position Open I nter est • L ong Ver sus Shor t Offsetting Ver sus D eliver y D aily L imit M ar gin Requir ements • I nitial • M aintenance F utur es M ar k ets I nstr uments P hysical to F inancial Physical Commodities C ommodities Only the Best Contr acts Sur vive CM E, CBOT , and Other s Options M ar k ets O ptions Call Ver sus Put Options A mer ican Ver sus Eur opean Amer Options O ptions Wr iter Ver sus Buyer Cover ed Ver sus N ak ed Options C har acter istics of Options O ptions Str ik e or Exer cise Pr ice (- or +) P r ice of U nder lying Secur ity (+ or Pr -) -) T ime to M atur ity (+) Volatility (+) Risk -fr ee Rate (+ or -) Option Payoff Char ts O ption Call Option Option Payoff Char ts O ption Put Option Options Ver sus F utur es O ptions Potential L oses Right Ver sus Obligation Pr emium Par ticipants P ar H edger s Speculator s T r ader s Regulation R egulation CF T C SEC Exchange U se of F inancial F utur es I nstr uments L ock in Commodity Pr ice (Seller ) L ock in Commodity Pr ice (Buyer ) L ock in I nter est Rate (Seller /Bor r ow er ) ( Seller L ock in I nter est Rate (Buyer /I nvestor ) ( Buyer R educing Risk in a Stock Reducing Por tfolio P or L ock in Commodity Pr ice (Seller ) ( Seller Spr ing • F ar mer anticipates having 80,000 bushels of cor n at har vest time of Objective • O bjective is to lock in a pr ice for D ecember deliver y d eliver • Cur r ent cash pr ice is $2.855/bushel • 5,000 bushels/contr act • F utur es Pr ices • • • M ay J uly July D ecember 299 2 cents/bushel 299 301 3 cents/bushel 301 289 2 cents/bushel L ock in Commodity Pr ice (Seller ) ( Seller F ar mer has 3 choices • D o nothing and hope D ecember pr ice r ises pr • H edge w ith futur es and lock in a p r ice of 289 2 cents/bushel 289 • U se options to lock in a minimum pr ice H edging Sell • Sell 16 D ecember futur es contr acts at 289 a cents/bushel for $231,600 at (80,000 • ( 80,000 bushels/5,000 bushels per L ock in Commodity Pr ice (Seller ) ( Seller N ow far mer has both cash and futur es positions f utur What if cor n in D ecember is $3.25/ bushel? • F ar mer gets $260,000 on the cash position p osition • 80,000 * $3.25 = $260,000 • F ar mer loses $28,400 on the futur es position p osition ( $2.895 - $3.25) * 80,000 = -$28,400 L ock in Commodity Pr ice (Seller ) ( Seller What if cor n in D ecember is $2.75? • F ar mer gets $220,000 on the cash position p osition • 80,000 * $2.75 = $220,000 • F ar mer gains $11,400 on the futur es position p osition • ( $2.895 - $2.75) * 80,000 = $11,600 • N et position is $231,600 • $220,000 + $11,600 = $231,600 L ock in Commodity Pr ice (Seller ) ( Seller F ar mer buys 16 put options w ith a str ik e pr ice of $3 at 26.25 cents per bushel p er 16 • 16 contr acts * 5,000 bushels/contr act * $0.2625/bushel = $21,000 $0.2625/bushel L ock in Commodity Pr ice (Seller ) ( Seller What if cor n in D ecember is $3.25? • F ar mer gets $260,000 on the cash position p osition • 80,000 * $3.25 = $260,000 • F ar mer lets the put options expir e • Cost is $21,000 • N et Position is $239,000 • $260,000 - $21,000 L ock in Commodity Pr ice (Seller ) ( Seller What if cor n in D ecember is $2.75? • F ar mer gets $220,000 on the cash position p osition • 80,000 * $2.75 = $220,000 • F ar mer sells the put options for a gain of $20,000 gain • ($3.00 - $2.75) * 80,000 = $20,000 • N et Position is $219,000 • $220,000 + $20,000 - $21,000 L ock in Commodity Pr ice (Seller ) ( Seller N et Results $.5 2 7 $. 5 32 D Nt in $ 2 , 0 $ 6 , 0 o oh g 2 0 0 2 0 0 0 0 Ft r s uue Ot n pio s $ 3, 0 $ 3, 0 21 0 21 0 6 6 $ 1, 0 $ 3 , 0 290 0 2 90 0 L ock in Commodity Pr ice (Buyer ) ( Buyer Spr ing • L evi’s anticipates needing 1,000,000 pounds of cotton in October p ounds • Objective is to lock in a cost for October • Cur r ent cash pr ice is $.6919/pound • 50,000 pounds/contr act • F utur es Pr ices • October $.7480/pound • Why not buy cotton now at the low er cost? L ock in Commodity Pr ice (Buyer ) ( Buyer L evi’s has 3 choices • D o nothing and hope October pr ices fall f all • H edge w ith futur es and lock in a pr ice of $.7480/pound pr • U se options to lock in a maximum pr ice H edging Buy • B uy 20 October futur es contr acts at $.7480/pound for $748,000 $.7480 ( 1,000,000 pounds/50,000 pounds per (1,000,000 L ock in Commodity Pr ice (Buyer ) ( Buyer N ow L evi’s has both cash and futur es positions f utur W hat if cotton in October is What $.80/pound? $.80/pound? • L evi’s pays $800,000 on the cash position p osition • -$.80 * 1,000,000 = -$800,000 • L evi’s gains $52,000 on the futur es position p osition ($ .80 - $.7480) * 1,000,000 = $52,000 L ock in Commodity Pr ice (Buyer ) ( Buyer W hat if cotton in October is What $.71/pound? $.71/pound? • L evi’s pays $710,000 on the cash position p osition • -$.71 * $1,000,000 = -$710,000 • F ar mer loses $38,000 on the futur es position p osition • ( $.71 - $.7480) * 1,000,000 = -$38,000 • N et cost is $748,000 • -$710,000 - $38,000 = -$748,000 L ock in Commodity Pr ice (Buyer ) ( Buyer L evi’s buys 20 call options w ith a str ik e pr ice of $.75 at 3.02 cents per pound p er 20 • 20 contr acts * 50,000 p ounds/contr act * $0.0302/pound = $30,200 $30,200 L ock in Commodity Pr ice (Buyer ) ( Buyer What if cotton in October is $.80? • L evi’s pays $800,000 on the cash position p osition • $.80 * 1,000,000 = $800,000 • L evi’s sells option for a gain of $50,000 $50,000 • ($.80 - $.75) * 1,000,000 = $50,000 • N et cost is $780,200 • -$800,000 + $50,000 - $30,200 L ock in Commodity Pr ice (Buyer ) ( Buyer What if cotton in October is $.71? • L evi’s pays $710,000 on the cash position p osition • $.71 * 1,000,000 = $710,000 • • L evi’s lets call options expir e N et cost is $740,200 • -$710,000 - $30,200 L ock in Commodity Pr ice (Buyer ) ( Buyer N et Results $ .1 07 D Nt in o oh g Ft r s uue O io s pn t $. 0 08 $ 1, 0 $ 0 , 0 70 0 8 0 0 0 0 $4 , 0 $4 , 0 78 0 78 0 0 0 $4 , 0 $8 , 0 70 0 70 0 2 0 L ock in I nter est Rate (Bor r ow er ) ( Bor N ovember We • W e N eed to Bor r ow $5,000,000 in D ecember for 90 D ays We • W e Estimate Our Bor r ow ing Costs to Be 1% Over the Eur odollar Rate Be We • W e Want to L ock in the Effective Rate We Will Pay R ate L ock in I nter est Rate (Bor r ow er ) ( Bor Eur odollar contr act $1,000,000 F ace Value 90 D ay Contr act D ecember Quote is 93.35 B ank D iscount Yield = 100 - 93.35 = Bank 6.65% 6.65% • Pr ice Per Contr act • • • • $1,000,000 • $1,000,000 * [1 - (.0665 * 90/360)] = $983,375 $983,375 Value of Basis Point is $25 L ock in I nter est Rate (Bor r ow er ) ( Bor Estimated I nter est Expense $5,000,000 • $5,000,000 * (6.65% + 1%) * 90/365 = $94,315 $94,315 • T o L ock in Expense, We Sell F utur es Contr acts C ontr Objective • O bjective I s to M ak e M oney When Rates Rise R ise • Contr acts N eeded $Secur • $Secur ity/$Contr act * M at. of Secur ity/M at. of L ock in I nter est Rate (Bor r ow er ) ( Bor I f Eur odollar Rates Rise to 7% • Our Bor r ow ing Costs I ncr ease to 8% • $5,000,000 * 8% * 90/365 = $98,630 • F utur es Contr acts I ncr ease I n Value (35 • 5 * ( 35 Basis Points * $25/Basis Point) = $4,375 $4,375 • N et Cost • $98,630 - $4,375 = $94,255 L ock in I nter est Rate (Bor r ow er ) ( Bor I f Eur odollar Rates F all to 6.25% • Our Bor r ow ing Costs F all to 7.25% • $5,000,000 * 7.25% * 90/365 = $89,384 • F utur es Contr acts D ecr ease I n Value (40 • 5 * ( 40 Basis Points * $25/Basis Point) = $5,000 $5,000 • N et Cost • $89,384 + $5,000 = $94,384 L ock in I nter est Rate (Bor r ow er ) ( Bor N et Result • T otal Cost Eooa u dl r 7 0 r l .% 0 Re a t 65 .% 2 $9 8 8, 4 3 $4 8 9, 4 3 DNh g oo i tn Fu s ur te $8 3 9, 0 6 $4 5 9, 5 2 L ock in I nter est Rate (I nvestor ) (I Apr il We • W e Will H ave $5,000,000 to I nvest in June for 30 D ays J une We • W e Want to L ock in the Effective Yield We Will Ear n Y ield L ock in I nter est Rate (I nvestor ) (I L I BOR Contr act • • • • $3,000,000 F ace Value 30 D ay Contr act June Quote is 94.13 Bank D iscount Yield • 100 - 94.83 = 5.17% • Pr ice Per Contr act $3,000,000 • $3,000,000 * [1 - (.0517* 30/360) = $2,987,075 $2,987,075 Value of Basis Point is $25 L ock in I nter est Rate (I nvestor ) (I Estimated I nter est Revenue • $5,000,000 * 5.17% * 30/365 = $21,247 • T o L ock in I ncome, We Buy F utur es Contr acts C ontr Objective • O bjective is to M ak e M oney When Rates F all • Contr acts N eeded $5,000,000/$3,000,000 • $5,000,000/$3,000,000 * 1.67 1.67 • So We Buy Either 1 or 30 days/30 days = 2 Contr acts L ock in I nter est Rate (I nvestor ) (I I f Rates F all to 4.75% • Our I nter est I ncome F alls • $5,000,000 * 4.75% * 30/365 = $19,521 • F utur es Contr acts I ncr ease in Value 42 • 1 * 42 Basis Points * $25/Basis Point = $1,050 $1,050 42 • 2 * 42 Basis Points * $25/Basis Point = $2,100 $2,100 • N et I ncome • $19,521 + $1,050 = $20,571 L ock in I nter est Rate (I nvestor ) (I I f Rates Rise to 5.5% • Our I nter est I ncome Rises • $5,000,000 * 5.5% * 30/365 = $22,603 • F utur es Contr acts D ecr ease in Value 33 • 1 * 33 Basis Points * $25/Basis Point = $825 $825 33 • 2 * 33 Basis Points * $25/Basis Point = $1,650 $1,650 • N et I ncome • $22,603 - $825 = $21,778 L ock in I nter est Rate (I nvestor ) (I N et Result 45 .% 7 D Nt in o oh g 1 uue Ft r s 2 uue Ft r s $95 1 1, 2 $0 7 2, 1 5 $12 2, 1 6 55 % .0 $2 0 2, 3 6 $ 17 2, 8 7 $0 5 2, 3 9 Other Ar eas O ther Reducing Risk in F or eign T r ade Reducing Risk in a Por tfolio Reducing Balance Sheet Risk W hy H edges Ar e I mper fect Basis Risk Contr act Size D eliver y D ates M atur ity of U nder lying Contr act T r ansaction Costs I nter est Rate Sw aps U sually Br ought T ogether By a aia le Fe ix d M ajor Bank Vr b Rt ae Rt ae H h L O +1 ig IBR % Ce itR k r d is Lw o Ce itR k r d is LO IBR 1% 2 9 % I nter est Rate Sw aps H igh Cr edit Risk (H CR) Wants to Bor r ow at a F ixed Rate B or L ow Cr edit Risk (L CR) Wants to Bor r ow at a Var iable Rate B or H CR Bor r ow s at the Var iable R ate and Pays a F ixed Rate to the L CR L CR Bor r ow s at the F ixed Rate a nd Pays a Var iable Rate to the I nter est Rate Sw aps H CR • Bor r ow s at L I BOR + 1% • Pays 9.5% to L CR L CR • Bor r ow s at 9% • Pays L I BOR - .5% to H CR I nter est Rate Sw aps N et Results • H CR • • • • Gets L I BOR - .5% F r om L CR Pays 9.5% to L CR Pays L I BOR + 1% to L ender N et I s 11% Ver sus 12% Without a Sw ap I nter est Rate Sw aps N et Results • L CR • • • • Gets 9.5% F r om H CR Pays L I BOR - .5% to H CR Pays 9% to L ender N et is L I BOR - 1% Ver sus L I BOR Without a Sw ap W ithout T ax and Accounting I mplications G ains F r om H edging and Gains Speculating Ar e U sually T axable As Or dinar y I ncome As L osses F r om H edging Can Offset Or dinar y I ncome Or L oses F r om Speculating Can Only B e U sed to Offset Gains F r om Speculating Speculating ...
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This note was uploaded on 04/02/2009 for the course DEPARTMENT FIN 4320 taught by Professor Sherwoodbishop during the Spring '08 term at Southwestern.

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