Derivatives for Managing Financial Risk

Contents:Advantages of risk managementDerivatives 1. Option 2. Forward contracts 3. Future contracts 4. SwapUse of derivatives .

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Derivatives and Risk Hedging A derivative is a financial instrument

whose pay-offs is derived from some other asset which is called as an underlying asset.

There are a large number of simple derivatives like futures or forward contracts or swaps. Options are more complicated derivatives.

Derivatives are tools to reduce a firm’s risk exposure. Hedging is the term used for reducing risk by using derivatives.

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Advantages of Risk Management through Hedging

Debt capacity enhancement

Increased focus on operations

Isolating managerial performance

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Risk Hedging with OptionsAn option is a right to buy or sell an asset at

a specified exercise price at a specified period of time.

Foreign currency option is a handy method of reducing foreign exchange risk. Similarly, options on interest rates and commodities are quite popular with managers to reduce risk.

Many options trade on option exchanges. However, in practice, banks and companies strike private option deals.

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ExampleSuppose ONGC sells oil to IPCL. ONGC wants to

protect itself from a potential fall in oil prices. It should buy a put option – a right to sell oil at a specified exercise price at a specified time. ONGC will be able to protect itself from falling prices and at the same time benefit from increase in the oil prices.

ONGC buys the put option with the Rs 25,000 exercise price at a premium of Rs 50 per barrel. If the price of oil on the day option expires is less than the exercise price, ONGC will exercise the option since it will fetch the locked in price of Rs 25,000 per barrel. On the other hand, if the oil price is more than the exercise price, it will allow the option to lapse as it can get sell the oil at a higher price. In both situations there is a cost in the form of option premium involved.

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ExampleA goldsmith plans to purchase 1,000 troy ounces of gold

in three months. He suspects fluctuations in the gold prices. The price could be $320, $340 or $360 an ounce. The goldsmith is thinking of buying a 3-month call option on 1,000 ounces of gold with an exercise price of $340. The option will cost $4 per ounce. The goldsmith would exercise the call option when the gold price is more than the exercise price, otherwise he would allow it to lapse.

Gold Price, Rupees per ounce $320 $340 $360 Cost of 1,000 ounces 320,000 340,000 360,000 Less: payoff on call option 0 0 20,000 Plus: option premium 4,000 4,000 4,000 324,000 344,000 344,000

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Forward ContractsA forward contract is an agreement between

two parties to exchange an asset for cash at a predetermined future date for a price that is specified today.

In case of a forward contract, both the buyer and the seller are bound by the contract while Under an option, the buyer has a right to decide whether or not she would exercise the option.

Forward contracts are flexible. They are tailor-made to suit the needs of the buyers and sellers. Foreign currencies forwards have the largest trading.

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ExampleAn Indian company has ordered machinery from USA.

The price of $ 500,000 is payable after six months. The current exchange rate is Rs45.75/$. At the current exchange rate, the company would need: 45.75 × 500,000 = Rs 22,875,000. But the company anticipates depreciation of Indian rupee over time. The cost to the company in Indian rupees will increase if rupee depreciates when payment is made after six months. What should the company?

The company can lock in the exchange rate by entering into a forward contract and forget about any fluctuation in the exchange rate. Suppose the six-month forward exchange rate is Rs45.95. The company can buy dollars forward. At the time of making payment, it will exchange Rs 22,975,000 for buying $500,000.

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Futures ContractsFuture contracts are forwards contracts traded on

organised exchanges in standardised contract size. For example, the standard contract size for barley in the barley international exchange is 20 metric ton.

The short hedge is a common occurrence in business, and it takes place whenever a firm or an individual is holding goods or commodities (or any other asset) or is expecting to receive goods or commodities

Generally, a long hedge occurs when a person or the firm is committed to sell at a fixed price.

Unlike options but like forward contracts, future contracts are obligations; on the due date the seller (farmer) has to deliver barley to the buyer (miller) and the buyer will pay the seller the agreed price. In the futures contracts, like in the forward contracts, one partly would lose and another will gain.

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ExampleA coal mining company is

concerned about short-term volatility in its revenues. Coal currently sells for Rs 7,000 per ton. But the price could fall as low as Rs 6,500 per ton or as high as Rs 7,400 per ton. The company will supply about 5,000 tons to the market next month. What are the consequences if the company does not hedge? What is the cost to the company if it enters into a futures contract to deliver 5,000 tons of coal at an agreed price of Rs 7,050 per ton next month?

Hedging Risk:

Futures price

7,050 7,050 7,050

Spot price 7,400 7,000 6,500 Profit/loss -350 +50 +550

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Financial FuturesFinancial futures, like the commodity

futures, are contracts to buy or sell financial assets at a future date at a specified price. Financial futures, introduced for the first time in 1972 in USA, have become very popular. Now the trading in financial futures far exceeds trading in commodity futures.

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Futures Contracts Vs. Forward Contracts

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FORWARD CONTRACT FUTURE CONTRACT

No initial payment is required. Initial payment is required.

Contract size depends on the transaction and the requirements of the contracting parties.

Contract size is standardized.

Expiry date depends on the transaction.

Expiry date is standardized.

Negotiated directly by the buyer and seller.

Quoted and traded on the exchange.

Futures and Spot Prices of Financial FuturesThe price of an asset for immediate delivery

is known as the spot price. Under the futures contract, there will be no

out go of cash and the buyer has an opportunity of earning interest on the purchase price. But, since the buyer will not hold the asset, he will lose the opportunity of earning dividends.

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Futures price Spot price (1 ) dividend foregone

Future price Dividend foregoneSpot price

(1 ) (1 )

f

f f

t

t t

r

r r

Spot and Future Prices of Commodity FuturesThe spot and futures prices relationship in

case of commodities futures is given as follows:

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Future price Storage costs Convenience yieldSpot price

(1 ) (1 ) (1 )

Future price Storage costs Convenience yieldSpot price

(1 ) (1 ) (1 )

t t tf f f

t t tf f f

r r r

r r r

ExampleSuppose the spot price for wheat was $2.85

per bushel in September 2004. The one-year futures price was $3.38 per bushel. The interest rate is 6 per cent. What is the net convenience yield?

Net Convenience Yield as a percentage of spot price is: 0.34/2.85 = 0.119 or 11.9 per cent.

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1

3.382.85 PV(storage costs – convenience yield)

(1.06)

PV(NCY) = 3.19 2.85 $ 0.34

SwapsA swap is an agreement between two

parties, called counterparties, to trade cash flows over a period of time.

Two most popular swaps are:

1. Currency swap involves an exchange of cash payments in one currency for cash payments in another currency.

2. Interest rate swap allows a company to borrow capital at fixed (or floating rate) and exchange its interest payments with interest payments at floating rate (or fixed rate).

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ExampleMr. John is the portfolio manager in Osram

Mutual Fund Company. He has a debt fund that has invested Rs 200 million in long-term corporate debentures. He wants to convert the holding into a synthetic floating-rate portfolio. The portfolio pays 9 per cent fixed return. Assume that a swap dealer offers 9 per cent fixed for MIBOR (Mumbai Inter Borrowing Rate). What should Mr. John do?

Mr. John should swap receiving MIBOR on a notional principal of Rs 200 million in exchange for payment at 9 per cent fixed rate. The cash flows of portfolio will change with MIBOR as shown below:

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ExampleMIBOR Rate

8.50% 9.00% 9.50%

Fixed-rate portfolio return(9% × Rs 200 million)

18 18 18

+ Net cash flow on swap [(MIBOR – 0.09) × Rs 200 million]

–1 — 1

Net payment 17 18 19

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Use of DerivativesIn many countries, particularly the developing countries,

no derivatives or very few types of derivatives are available.

Even in developed economies where derivatives markets are well developed, all companies do not make full use of derivatives. Most surveys on the use of derivatives reveal that derivatives are popular among the large listed companies in US. About the half of publicly traded firms uses one or the other form of derivatives. Among the companies using derivatives, the most widely used derivatives are the interest rate derivatives and the foreign exchange rate derivatives.

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Use of Derivatives Contd.The objective of firms using derivatives is to

reduce the cash flow volatility and thus, to diminish the financial distress costs. This is consistent with the theory of risk management through derivatives. Some firms use derivatives not for for the purpose of hedging risk rather to speculate about futures prices.

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PRESENTATION BY:-Surabhi Jain & Udayan Singh

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