DERIVATIVES, AND RISK MANAGEMENT, LEFT-HAND FINANCING, AND LEVERAGED BUYOUTGroup 1

Jerold SaddiPamela BernabeJuliet delos SantosJenelle CanonizadoElvin Lee

Learning Objectives:After this session the FINMAN students would be able to:Know all necessary concepts regarding derivativesKnow all various left-hand financing schemes, including their advantages and disadvantagesKnow the mechanics of Leveraged buyout, its use, its advantages and disadvantages

What are derivatives?

Are financial instrument that derive their value from contractually required cash flows from some other security or index.

Example

http://www.youtube.com/watch?v=FLGRPYAtReo

What are the essential features of a derivative?A derivative is a financial instrumentValues changes in response to the changes in UNDERLYING variables.

No or minimum initial net investment

Settled at a future date by a net cash payment / settlement

What are the kinds/examples of derivatives?Option ContractForward ContractFutures ContractForeign Currency Exchange ContractInterest Rate Swap

Accounting for DerivativesAre to be considered as either assets or liabilities and should be reported in the balance sheet at fair value.Unrealized gain or loss from fedging transactions is presented depending on the type of hedging.Under the Fair Value hedge method part of incomeUnder Cash Flow Hedge Method part of EQUITY

For foreign entity investment:Changes in fair Value determined to be an effective hedge are recognized in EQUITY.The ineffective portion of the changes in fair value are recognized in EARNINGS IMMEDIATELY if the hedging instrument is a derivative.

Why do derivatives exist?Hedging - Pertains to designating one or more hedging instruments so that their change in fair value is an offset, in whole or in part, to the change in fair value or cash flows of a hedged item.

http://www.youtube.com/watch?v=kBtrxAjtG04

FORWARD CONTRACTAtransactionin which aselleragreesto deliver a specificcommodityto abuyerat some point in thefuture. Read more:http://www.investorwords.com/2060/forward_contract.html#ixzz1zDZdjqWa

Example

Pamela BernabeCall/ put OptionsFinancial Futures

A derivatives financial instrument that specifies a contract giving its owner the right to buy or sell an asset at a fixed price on or before a given date.

Its also a unique type of financial contract because they give the buyer the right, but not the obligation, to do something.

The buyer uses the option only if it is adventageous to do so; otherwise the option can be thrown away

Give the marketplace opportunities to adjust risk or alter income streams that would otherwise not be available

Provide financial leverage

Can be used to generate additional income from investment portfoliosOPTIONS

Thales ancient Greek philosopherLOW STRIKEOLIVE SEASON HIGH

EXAMPLE Supposedly the first option buyer in the world was the ancient Greek mathematician and philosopher Thales of Miletus. On a certain occasion, it was predicted that the season's olive harvest would be larger than usual, and during the off-season he acquired the right to use a number of olive presses the following spring. When spring came and the olive harvest was larger than expected he exercised his options and then rented the presses out at much higher price than he paid for his 'option'.

OPTION TERMINOLOGYOption Seller - One who gives/writes the option. He has an obligation to perform, in case option buyer desires to exercise his option. Option Buyer - One who buys the option. He has the right to exercise the option but no obligation. Call Option - Option to buy. Put Option - Option to sell.

OPTION TERMINOLOGYAmerican Option - An option which can be exercised anytime on or before the expiry date. Strike Price/ Exercise Price - Price at which the option is to be exercised. Expiration Date - Date on which the option expires. European Option - An option which can be exercised only on expiry date. Exercise Date - Date on which the option gets exercised by the option holder/buyer. Option Premium - The price paid by the option buyer to the option seller for granting the option.

CALL OPTIONSA call option gives you the right to buy within a specified time period at a specified price

The owner of the option pays a cash premium to the option seller in exchange for the right to buy

PRACTICAL EXAMPLE OF A CALL OPTION

CALL OPTIONS - ILLUSTRATIONAn investor buys one European Call option on one share of Neyveli Lignite at a premium of Rs.2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. It may be clear form the graph that even in the worst case scenario, the investor would only lose a maximum of Rs.2 per share which he/she had paid for the premium. The upside to it has an unlimited profits opportunity. On the other hand the seller of the call option has a payoff chart completely reverse of the call options buyer. The maximum loss that he can have is unlimited though a profit of Rs.2 per share would be made on the premium payment by the buyer.

PUT OPTIONSA put option gives you the right to sell within a specified time period at a specified price

It is not necessary to own the asset before acquiring the right to sell it

An investor buys one European Put Option on one share of Neyveli Lignite at a premium of Rs. 2 per share on 31 July. The strike price is Rs.60 and the contract matures on 30 September. The adjoining graph shows the fluctuations of net profit with a change in the spot price.

CALL/PUT OPTIONS

All exchange-traded options have standardized expiration datesThe Saturday following the third Friday of designated months for most options

Investors typically view the third Friday of the month as the expiration date

The striking price of an option is the predetermined transaction price In multiples of $2.50 (for stocks priced $25.00 or below) or $5.00 (for stocks priced higher than $25.00)

There is usually at least one striking price above and one below the current stock price

STANDARDIZED OPTION CHARACTERISTICS

Puts and calls are based on 100 shares of the underlying security

The underlying security is the security that the option gives you the right to buy or sell

It is not possible to buy or sell odd lots of options

STANDARDIZED OPTION CHARACTERISTICS

FINANCIAL FUTURES

Forwards a contract that is customized between two entities, where settlement takes place on a specific date in the future at todays pre-agreed price

Futures an agreement between two parties to buy or sell an asset to a certain time in the future at a certain price. - it is also a special types of forward contracts in the sense that the former standardized exchange-traded contracts.

SIMPLE EXAMPLEIf you agree in April with your Aunt Sue that you will buy two pounds of tomatoes from her garden for $5, to be delivered to you when they're ripe in July, you and Sue just entered into a futures contract.

A financial future is a futures contract on a short term interest rate (STIR). Contracts vary, but are often defined on an interest rate index such as 3-month sterling or US dollar LIBOR.

They are traded across a wide range of currencies, including the G12 country currencies and many others.

The assets often traded in futures contracts include commodities, stocks, and bonds. Grain, precious metals, electricity, oil, beef, orange juice, and natural gas are traditional examples of commodities, but foreign currencies, emissions credits, bandwidth, and certain financial instruments are also part of today's commodity markets. FINANCIAL FUTURES

Some representative financial futures contracts are:United States90-day Eurodollar *(IMM)1 mo LIBOR (IMM)Fed Funds 30 day (CBOT)Europe3 mo Euribor (Euronext.liffe)90-day Sterling LIBOR (Euronext.liffe)Euro Sfr (Euronext.liffe)Asia3 mo Euro yen (TIF)90-day Bank Bill (SFE)whereIMM is the International Money Market of the Chicago Mercantile ExchangeCBOT is the Chicago Board of TradeTOCOM is the Tokyo Commodity ExchangeSFE is the Sydney futures exchange

FINANCIAL FUTURES

COMPARISON OF FUTURES AND FORWARD

FuturesForwardAmountStandardizedNegotiatedDelivery DateStandardizedNegotiatedCounter-partyClearinghouseBankCollateralMargin Acct.NegotiatedMarketAuction MarketDealer MarketCostsBrokerage and exchange feesBid-ask spreadLiquidityVery liquidHighly illiquidRegulationGovernmentSelf-regulatedLocationCentral exchangeWorldwide

ADVANTAGE AND DISADVANTAGE OF FINANCIAL FUTURESAdvantagesSmall Contract SizeEasy liquidationWell organized and stable market (no risk of default)

DisadvantagesLimited number of currencies (but think about how one futures might be a close hedge against another currency)Rigid contract sizeFixed expiration dates (but if you can get close, it doesnt matter all that much).

THERE ARE TWO TYPES OF ORGANIZATIONS THAT FACILITATE FUTURES TRADING:

ExchangeExchanges are non-profit or for-profit organizations that offer standardized futures contracts for physical commodities, foreign currency and financial products.

ClearinghouseA clearinghouse is agency associated with an exchange, which settles trades and regulates delivery. Clearinghouses guarantee the fulfillment of futures contract obligations by all parties involved.

AN EXAMPLE:90-DAY EURODOLLAR TIME DEPOSIT FUTURESEurodollar futures contracts are traded on the International Monetary Market (IMM), a division of the Chicago Mercantile Exchange. The underlying asset is a Eurodollar time deposit with a 3-month maturity.Eurodollar rates are quoted on an interest-bearing basis, assuming a 360-day year.Each Eurodollar futures contract represents $1 million of initial face value of Eurodollar deposits maturing three months after contract expiration. Forty separate contracts are traded at any point in time, as contracts expire in March, June, September and December

AN EXAMPLE:90-DAY EURODOLLAR TIME DEPOSIT FUTURESEurodollar futures contracts trade according to an index that equals 100 percent minus the futures interest rate expressed in percentage terms.

An index of 91.50 indicates a futures rate of 8.5 percent. Each basis point change in the futures rate equals a $25 change in value of the contract (0.0001 x $1 million x 90/360).

The first column indicates the settlement month and year.Each row lists price and yield data for a distinct futures contract that expires sequentially every three months.The next four columns report the opening price, high and low price, and closing settlement price.The next column, headed Chg, states the change in settlement price from the previous day.The two columns under Yield convert the settlement price to a Eurodollar futures rate as:100 - settlement price = futures rateEURODOLLAR FUTURES

SPECULATING WITH FUTURES, LONGBuying a futures contract (today) is often referred to as going long, or establishing a long position.

Recall: Each futures contract has an expiration date. Every day before expiration, a new futures price is established. If this new price is higher than the previous days price, the holder of a long futures contract position profits from this futures price increase. If this new price is lower than the previous days price, the holder of a long futures contract position loses from this futures price decrease.

EXAMPLE I: SPECULATING IN GOLD FUTURESYou believe the price of gold will go up. So,You go long 100 futures contract that expires in 3 months.The futures price today is $400 per ounce.There are 100 ounces of gold in each futures contract. Your "position value" is: $400 X 100 X 100 = $4,000,000 Suppose your belief is correct, and the price of gold is $420 when the futures contract expires.

Your "position value" is now: $420 X 100 X 100 = $4,200,000

Your "long" speculation has resulted in a gain of $200,000

What would have happened if the gold price was $370?

SPECULATING WITH FUTURES, SHORTSelling a futures contract (today) is often called going short, or establishing a short position.

Recall: Each futures contract has an expiration date. Every day before expiration, a new futures price is established. If this new price is higher than the previous days price, the holder of a short futures contract position loses from this futures price increase. If this new price is lower than the previous days price, the holder of a short futures contract position profits from this futures price decrease.

EXAMPLE II: SPECULATING IN GOLD FUTURESYou believe the price of gold will go down. So,You go short 100 futures contract that expires in 3 months.The futures price today is $400 per ounce.There are 100 ounces of gold in each futures contract. Your "position value" is: $400 X 100 X 100 = $4,000,000 Suppose your belief is correct, and the price of gold is $370 when the futures contract expires.

Your position value is now: $370 X 100 X 100 = $3,700,000

Your "short" speculation has resulted in a gain of $300,000

What would have happened if the gold price was $420?

INTEREST RATE SWAPSJuliet Delos Santos

Swaps ContractsIn a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals.There are two types of interest rate swaps:Single currency interest rate swapPlain vanilla fixed-for-floating swaps are often just called interest rate swaps.Cross-Currency interest rate swapThis is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

Swap BankA swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties.The swap bank can serve as either a broker or a dealer.As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap.As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

Example: Interest Rate SwapConsider this example of a plain vanilla interest rate swap.Bank A is a AAA-rated international bank located in the U.K. and wishes to raise $10,000,000 to finance floating-rate Eurodollar loans.Bank A is considering issuing 5-year fixed-rate Eurodollar bonds at 10 percent.It would make more sense to for the bank to issue floating-rate notes at LIBOR (London Interbank Offered Rate) to finance floating-rate Eurodollar loans.

Example: Interest Rate Swap (cont.)Firm B is a BBB-rated U.S. company. It needs $10,000,000 to finance an investment with a five-year economic life.Firm B is considering issuing 5-year fixed-rate Eurodollar bonds at 11.75 percent.Alternatively, firm B can raise the money by issuing 5-year floating-rate notes at LIBOR + percent.Firm B would prefer to borrow at a fixed rate.

Example: Interest Rate Swap (cont.)The borrowing opportunities of the two firms are:

Company B

Bank A

Fixed rate

11.75%

10%

Floating rate

LIBOR + .5%

LIBOR

The swap bank makes this offer to Bank A: You pay LIBOR 1/8 % per year on $10M for 5 yrs. and we will pay you 10 3/8% on $10M for 5 yrs.Swap BankBank AExample: Interest Rate Swap (cont.)

Company B

Bank A

Fixed rate

11.75%

10%

Floating rate

LIBOR + .5%

LIBOR

Heres whats in it for Bank A: They can borrow externally at 10% fixed and have a net borrowing position of -10 3/8 + 10 + (LIBOR 1/8) =LIBOR % which is % better than they can borrow floating without a swap. % of $10M = $50K. Thats quite a cost savings per yr. for 5 yrs.Swap BankBank AExample: Interest Rate Swap (cont.)

Company B

Bank A

Fixed rate

11.75%

10%

Floating rate

LIBOR + .5%

LIBOR

Company BThe swap bank makes this offer to company B: You pay us 10% per year on $10 million for 5 years and we will pay you LIBOR % per year on $10 million for 5 years.Swap BankExample: Interest Rate Swap (cont.)

Company B

Bank A

Fixed rate

11.75%

10%

Floating rate

LIBOR + .5%

LIBOR

25-*They can borrow externally at LIBOR + % and have a net borrowing position of 10 + (LIBOR + ) - (LIBOR - ) = 11.25% which is % better than they can borrow floating. LIBOR + %Heres whats in it for B: % of $10M = $50K thats quite a cost savings per yr. for 5 yrs.Swap BankCompany BExample: Interest Rate Swap (cont.)

Company B

Bank A

Fixed rate

11.75%

10%

Floating rate

LIBOR + .5%

LIBOR

25-*The swap bank makes money too.% of $10M= $25,000 per yr. for 5 yrs.LIBOR 1/8 [LIBOR ]= 1/8 10 - 10 3/8 = 1/8 Swap BankCompany BBank AExample: Interest Rate Swap (cont.)

Company B

Bank A

Fixed rate

11.75%

10%

Floating rate

LIBOR + .5%

LIBOR

25-*Swap BankCompany BBank AB saves %A saves %The swap bank makes %Example: Interest Rate Swap (cont.)

Company B

Bank A

Fixed rate

11.75%

10%

Floating rate

LIBOR + .5%

LIBOR

Example: Currency SwapSuppose a U.S. MNC wants to finance a 10M expansion of a British plant.They could borrow dollars in the U.S. where they are well known and exchange for dollars for pounds.This will give them exchange rate risk: financing a sterling project with dollars.They could borrow pounds in the international bond market, but pay a premium since they are not as well known abroad.

Example: Currency Swap (cont.)If they can find a British MNC with a mirror-image financing need they may both benefit from a swap.If the spot exchange rate is S0($/) = $1.60/, the U.S. firm needs to find a British firm wanting to finance dollar borrowing in the amount of $16M.

Example: Currency Swap (cont.)Consider two firms A and B: firm A is a U.S.based multinational and firm B is a U.K.based multinational.Both firms wish to finance a project in each others country of the same size. Their borrowing opportunities are given in the table below.

$

Company A

8.0%

11.6%

Company B

10.0%

12.0%

Example: Currency Swap (cont.)$8%12%Firm BSwap BankFirm A$9.4%As net position is to borrow at 11%A savaes .6%

$

Company A

8.0%

11.6%

Company B

10.0%

12.0%

Example: Currency Swap (cont.)$8%12%Firm BSwap BankFirm A$9.4%Bs net position is to borrow at $9.4%B saves $.6%

$

Company A

8.0%

11.6%

Company B

10.0%

12.0%

Example: Currency Swap (cont.)$8%12%Firm BThe swap bank makes money too:At S0($/) = $1.60/, that is a gain of $64,000 per year for 5 years.The swap bank faces exchange rate risk, but maybe they can lay it off (in another swap).1.4% of $16 million financed with 1% of 10 million per year for 5 years.Swap BankFirm A$9.4%

$

Company A

8.0%

11.6%

Company B

10.0%

12.0%

Variations of Basic SwapsCurrency Swapsfixed for fixed fixed for floatingfloating for floatingamortizingInterest Rate Swaps zero-for floatingfloating for floatingExoticaFor a swap to be possible, two humans must like the idea. Beyond that, creativity is the only limit.

25-*Risks of Interest Rate and Currency SwapsInterest Rate RiskInterest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.Basis RiskIf the floating rates of the two counterparties are not pegged to the same index.Exchange Rate RiskIn the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

Risks of Interest Rate and Currency SwapsCredit RiskThis is the major risk faced by a swap dealerthe risk that a counter party will default on its end of the swap.Mismatch RiskIts hard to find a counterparty that wants to borrow the right amount of money for the right amount of time.Sovereign RiskThe risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

Pricing a SwapA swap is a derivative security so it can be priced in terms of the underlying assets:How to:Plain vanilla fixed for floating swap gets valued just like a bond.Currency swap gets valued just like a nest of currency futures.

Derivatives Prevailing in the Philippine MarketForwardSwap (Interest or Asset)Options Credit-Linked NotesStructured Product Structured Yield Deposit

Source: BSP Circular 594

What is corporate risk management, and why is it important to all firms?Corporate risk management relates to the management of unpredictable events that would have adverse consequences for the firm.All firms face risks, but the lower those risks can be made, the more valuable the firm, other things held constant. Of course, risk reduction has a cost.

Definitions of different types of riskSpeculative risks offer the chance of a gain as well as a loss.Pure risks offer only the prospect of a loss.Demand risks risks associated with the demand for a firms products or services.Input risks risks associated with a firms input costs.Financial risks result from financial transactions.

Definitions of different types of riskProperty risks risks associated with loss of a firms productive assets.Personnel risk result from human actions.Environmental risk risk associated with polluting the environment.Liability risks connected with product, service, or employee liability.Insurable risks risks that typically can be covered by insurance.

What are the three steps of corporate risk management?Identify the risks faced by the firm.Measure the potential impact of the identified risks.Decide how each relevant risk should be handled.

What can companies do to minimize or reduce risk exposure?Transfer risk to an insurance company by paying periodic premiums.Transfer functions that produce risk to third parties.Purchase derivative contracts to reduce input and financial risks.Take actions to reduce the probability of occurrence of adverse events and the magnitude associated with such adverse events.Avoid the activities that give rise to risk.

Leasing and Other Asset-Based FinancingCorporate Financial Management 3e Emery Finnerty Stowe Modified for course use by Arnold R. Cowan

*Lease FinancingA lease is a rental agreement that extends for one year or longer.The owner of the asset (the lessor) grants exclusive use of the asset to the lessee for a fixed period of time.In return, the lessee makes fixed periodic payments to the lessor.At termination, the lessee may have the option to either renew the lease or purchase the asset.

*Types of LeasesFull-service leaseLessor responsible for maintenance, insurance, and property taxes.Net leaseLessee responsible for maintenance, insurance, and property taxes.

*Types of LeasesOperating leaseshort-termmay be cancelableFinancial leaselong-termsimilar to a loan agreement

*Types of Lease FinancingDirect leasesSale-and-lease-back agreementsLeveraged leases

*Direct LeaseLesseeLesseeLessorManufacturer/ Lessoror

*Sale-and-Lease-BackLesseeLessor

*Leveraged Lease

*Synthetic LeasesFirms have used synthetic leases to get the use of assets but keep debt off their balance sheets.An unrelated financial institution invests some equity and sets up a special-purpose-entity that buys the assets and leases it to the firm under an operating lease.Since the Enron bankruptcy, firms have been reluctant to use synthetic leases.

*Advantages of LeasesEfficient use of tax deductions and tax credits of ownershipReduced riskReduced cost of borrowingBankruptcy considerationsTapping new sources of fundsCircumventing restrictionsdebt covenantsoff-balance sheet financing

*Disadvantages of LeasingLessee forfeits tax deductions associated with asset ownership.Lessee usually forgoes residual asset value.

*Valuing Financial LeasesBasic approach is similar to debt refunding.Lease displaces debt.Missed lease payments can result in the lessorclaiming the asset.filing lawsuits.forcing firm into bankruptcy.Risk of a firms lease payments are similar to those of its interest and principal payments.

*Project FinancingDesirable whenProject can stand alone as an economic unit.Project will generate enough revenue (net of operating costs) to service project debt.Examples:Mines & mineral processing facilitiesPipelinesOil refineriesPaper mills

*Project Financing ArrangementsCompletion undertakingPurchase, throughput, or tolling agreementsCash deficiency agreements

*Advantages and Disadvantages of Project FinancingAdvantagesRisk sharingExpanded debt capacityLower cost of debtDisadvantagesSignificant transaction costs and legal feesComplex contractual agreementsLenders require a higher yield premium

*Limited Partnership FinancingAnother form of tax-oriented financing.Allows the firm to sell the tax deductions and credits associated with asset ownership to the limited partners.Income (or loss) for tax purposes flows through to the partners.Limited partners are passive investors.General partner operates the limited partnership and has unlimited liability.

Leveraged Buyouts (LBO)*LBOs are a way to take a public company private, or put a company in the hands of the current management, MBO. LBOs are financed with large amounts of borrowing (leverage), hence its name.LBOs use the assets or cash flows of the company to secure debt financing, bonds or bank loans, to purchase the outstanding equity of the company.After the buyout, control of the company is concentrated in the hands of the LBO firm and management, and there is no public stock outstanding.

History: LBO*Leveraged buyouts were a relatively obscure means of financing large corporate acquisitions in the post WWII period. The practice positively boomed in the 1980s, with a combined $188 billion in acquisitions taking place in 1988 alone. The term hostile takeover coined during this period, it reflects the mixed feelings towards LBO.

Successful LBO Strategies*Finding cheap assets buying low and selling high (value arbitrage or multiple expansion)

Unlocking value through restructuring:Financial restructuring of balance sheet improved combination of debt and equityOperational restructuring improving operations to increase cash flows

Key Terms and concepts regarding LBOs:Transaction fee amortization. This reflects the capitalization and amortization of financing, legal, and accounting fees associated with the transaction.- its like depreciation, is a tax-deductible noncash expense.

Interest Expense- For simplicity, interest expense for each tranche of debt financing is calculated based on the yearly beginning balance of each tranche.

Capitalization. Most leveraged buyouts make use of multiple tranches of debt to finance the transaction. A simple transaction may have only two tranches of debt, senior and junior. A large leveraged buyout will likely be financed with multiple tranches of debt that could include some or all of the following:Revolving credit facility (revolver). This is a source of funds that the bought-out firm can draw upon as its working capital needs dictate.

Bank debt. Often secured by the assets of the bought-ought firm, this is the most senior claim against the cash flows of the business. Mezzanine Debt exists in the middle of the capital structure and is junior to the bank debt incurred in financing the leveraged buyout.Subordinated or high yield notes (junk bonds) most junior source of debt financing and as such has the highest interest rates.Cash Sweep - is a provision of certain debt covenants that stipulates that any excess cash generated by the bought out business will be used to pay down principal.Exit Scenario usually involves either a sale of portfolio company or recapitalization.

*It gets complicated in a hurry.******************