SPECIAL TOPICS IN

FINANCIAL
MANAGEMENT
 USING
DERIVATIVES
TO REDUCE
RISKS 18.8

FIRMS ARE SUBJECT TO

SPECIAL TOPICS IN FINANCIAL

NUMEROUS RISKS RELATED
TO INTEREST RATE, STOCK

MANAGEMENT
PRICE, AND EXCHANGE RATE

FLUCTUATIONS IN THE
FINANCIAL MARKETS.
HOWEVER, DERIVATIVES ALSO
CAN BE USED TO REDUCE THE
RISKS ASSOCIATED WITH
FINANCIAL AND COMMODITY
MARKETS.
18.8A
SECURITY PRICE EXPOSURE

FIRMS ARE EXPECTED TO LOSSES DUE TO

CHANGES IN SECURITY PRICES WHEN
SECURITIES ARE HELD IN INVESTMENT
PORTFOLIO, AND FIRMS ARE EXPOSED TO
LOSSES WHEN SECURITIES ARE BEING
ISSUED. IN ADDITION, FIRMS ARE
EXPOSED TO RISK IF THEY USE
FLOATING-RATE DEBT TO FINANCE AN
INVESTMENT THAT PRODUCES A FIXED
INCOME STREAM.

DERIVATIVES ARE SECURITIES WHOSE VALUES STEM, OR

ARE DERIVED, FROM THE VALUES OF OTHER ASSETS.
18.8B

FUTURES
TAKE NOTE!
 SPECULATION INVOLVES BETTING ON
FUTURE PRICE MOVEMENTS, AND
FUTURES ARE USED BECAUSE OF THE

FUTURES ARE LEVERAGE

CONTRACT.
INHERENT IN THE

USED FOR BOTH

SPECULATION HEDGING IS DONE BY FIRM OR AN
INDIVIDUAL TO PROTECT AGAINST A

AND HEDGING PRICE CHANGE

OTHERWISE
THAT
NEGATIVELY
WOULD
AFFECT
PROFITS
 For example, rising interest rates
and commodity (raw materials)
prices can hurt profits, as can
adverse currency fluctuations. If
two parties have mirror-image
risks, they can enter into a
transaction that eliminates, as
opposed to transfer, risks.

THIS IS A “NATURAL HEDGE”

Thus, to the extent that speculator broaden the

market and make hedging possible, they help
decrease risk to those who seek to avoid it.
 THERE ARE TWO BASIC
TYPES OF HEDGES:
LONG HEDGES – IN WHICH FUTURE CONTRACTS ARE
BROUGHT IN ANTICIPATION OF (OR TO GUARD AGAINST)
PRICES INCREASE.

SHORT HEDGES – WHERE A FIRM OR AN INDIVIDUAL SELLS

FUTURE CONTRACTS TO GUARD AGAINST PRICE DECLINES.
THEREFORE, IFA FIRM OR
AN INDIVIDUAL NEEDS TO
GUARD AGAINST AN TO ILLUSTRATE, ASSUME THAT IN
THE MID-AUGUST, CARSON
INCREASE IN INTEREST FOODS IS CONSIDERING A PLAN
TO ISSUE $10,000,000 OF A 10-
RATE, A FUTURES YEAR BONDS IN DECEMBER TO
FINANCE A CAPITAL
CONTRACT THAT MAKES EXPENDITURE PROGRAM. THE
INTEREST RATE WOULD BE 6%
MONEY IF RATES RISE WITH SEMI-ANNUAL PAYMENTS IF

SHOULD BE USED. THE BONDS WERE ISSUED

TODAY, AND AT THAT RATE THE
PROJECT WOULD HAVE A
POSITIVE NPV
HOWEVER, INTEREST RATES MAY ARISE
OVER THE NEXT 4 MONTHS, AND WHEN
THE ISSUE IS SOLD, THE INTEREST RATE
MIGHT BE SUBSTANTIALLY ABOVE 6%,
WHICH WOULD MAKE THE PROJECT A
BAD INVESTMENT.
IN THIS SITUATIONS, CARSON WOULD
BE HURT BY AN INCREASE IN
INTEREST RATES, SO IT WOULD USE A
SHORT HEDGE. IT WOULD CHOOSE A
FUTURE CONTRACT ON THE SECURITY
MOST SIMILAR TO THE ONE IT PLANS
TO ISSUE, 10-YEAR BONDS. IN THIS
CASE, CARSON WOULD PROBABLY
HEDGE WITH U.S, 10-YEAR T-NOTES
FUTURES.
It would sell
$10,000,000/$100,000 = 100 T-
notes contracts for delivery in
December. Carson would have
to put up 100($1,430) =
$143,000 in margin money and
pay brokerage commissions.
We can see that each December contract
has a value of 126-135, or 126 plus so the
total value of the 100 contract is
1.26421875($100,000)(100) = $12,642,187.50.
Now suppose renewed fears of inflation
push the interest rate on Carson’s debt up
by 100 basis points, to 7% over the next 4
months. If Carson issued 6% semi-annual
coupon bonds, they would bring only
$928.94 per bond because investors now
require a 7% return.
THUS, CARSON WOULD LOSE $71.06 PER BONDS TIME
100,000 BONDS, OR $710,600, AS A RESULT OF DELAYING
THE FINANCING. HOWEVER, THE INCREASE IN INTEREST
RATES WOULD ALSO BRING ABOUT A CHANGE IN THE
VALUE OF CARSON’S SHORT POSITION IN THE FUTURES
MARKET. INTEREST RATE HAVE INCREASED, SO THE
VALUE OF THE FUTURE CONTRACTS WOULD FALL, AND IF
THE INTEREST RATE ON THE FUTURES CONTRACTS
INCREASED BY THE SAME FULL PERCENTAGE POINT,
FROM 2.93% TO 3.93% THE CONTRACTS VALUE WOULD
FALL TO $11,642,187.57. CARSON WOULD THE CLOSE ITS
POSITION IN THE FUTURES MARKET BY REPURCHASING
FOR $11,695,998.57 THE CONTRACTS THAT IT EARLIER
SOLD SHORT FOR $12,642,187.50, GIVING IT A PROFIT OF
$946,188.93, LESS COMMISSIONS.
 THUS, IF WE IGNORED
COMMISSIONS AND THE
OPPORTUNITY COST OF
THE MARGIN MONEY,
CARSON WOULD OFFSET
THE LOSS ON THE BOND
ISSUE.
IF FUTURES CONTRACTS WHICH GAINS ON THE FUTURES
EXISTED ON CARSON’S OWN CONTRACTS WOULD EXACTLY
DEBT AND INTEREST RATES OFFSET LOSSES ON THE BONDS.
IN REALITY, IT IS VIRTUALLY
MOVED IDENTICALLY IN THE IMPOSSIBLE TO CONSTRUCT
SPOT AND FUTURES PERFECT HEDGES BECAUSE IN
MARKETS, THE FIRM COULD MOST CASES THE UNDERLYING
ASSET IS NOT IDENTICAL TO
CONSTRUCT A PERFECT THE FUTURES ASSET, AND EVEN
HEDGE WHEN THEY ARE, PRICES (AND
INTEREST RATES) MAY NOT
MOVE EXACTLY TOGETHER IN
PERFECT HEDGE - occurs THE SPOT AND FUTURES
when the gain or loss on the MARKETS.
hedge transaction exaclty
offsets the loss or gain on the
unhedge position
NOTE TOO THAT IF CARSON HAD BEEN PLANNING
AN EQUITY OFFERING, AND IT STOCKS TENDED TO
MOVE FAIRLY CLOSELY WITH ONE OF THE STOCK
INDEXES, THE COMPANY COULD HAVE HEDGED
AGAINST FALLING STOCK PRICES BY SELLING
SHORT THE INDEX FUTURE.
The futures and option markets permit
flexibility in the timing of financial transactions
because the firm can be protected, at least
partially, against changes that occur between
the time a decision is reached and the time
the transaction is completed

Whether the protection is worth the cost is a matter

of judgement. The decision to hedge also depends on
management’s risk aversion as well as the company’s
strength and ability to assume the risk in question. In
theory, the reduction in risk resulting from a hedged
transaction should have a value equal to the cost of
the hedge.
Trammel Crow, a large Texas real
estate developer, has used T-bill
futures to lock in interest costs on
floating-rate construction loans,
while Kraft Heinz Company has used
Eurodollar futures to protect its
marketable securities portfolio.
Morgan Stanley and other investment
banking houses hedge in the futures
and options markets to protect
themselves when they are merged in
major underwritings.
18.8C SWAPS
 A swap is another method for reducing
FINANCIAL MANAGEMENT

financial risks. As noted earlier, a swap is

an exchange. In finance, it is an exchange
of cash payment obligations in which
each party to the swap prefers the
payment type or pattern of the other
party.
 SWAPS
Generally, one party has
a fixed-rate obligation;
or one party has an
obligation denominated
in another currency.
MAJOR CHANGES HAVE OCCURRED OVER TIME IN
THE SWAPS MARKET. STANDARDIZED CONTRACTS
HAVE BEEN DEVELOPED FOR THE MOST COMMON
TYPES OF SWAPS, AND THIS HAS HAD TWO
EFFECTS: (1) STANDARDIZED CONTRACTS LOWER
THE TIME AND EFFORT INVOLVED IN ARRANGING
SWAPS AND THUS LOWER TRANSACTIONS COSTS.
(2) THE DEVELOPMENT OF STANDARDIZED
CONTRACTS HAS LED TO A SECONDARY MARKET
FOR SWAPS, WHICH HAS INCREASED THE
LIQUIDITY AND EFFICIENCY OF THE SWAPS
MARKETS. A NUMBER OF INTERNATIONAL BANKS
NOW MAKE MARKETS IN SWAPS AND OFFER
QUOTES ON SEVERAL STANDARD TYPES.
To further illustrate swap transaction, consider the following
situation. An electric utility currently has outstanding a 5-year
floating-rate note tied to the prime rate. The prime rate could rise
significantly over the period, so the note carries a high degree of
interest rate risk. The utility could, however, enter into a swap with
a counterparty, (say CITI) wherein the utility would pay Citi a fixed
series of interest payments over the 5-year period, and Citi would
make the company’s required floating-rate payments. As a result,
the utility would have converted a floating-rate loan to a fixed-
rate loan and the risk of rising interest rates would have been
passed from the utility to Citi. Such transaction can lower both
parties’ risks because banks’ revenues rise as interest rates rise,
Citi’s risk would be lower if it had floating-rate obligations.
SEVERAL YEARS AGO, CITI ENTERED
INTO A 17-YEAR SWAP IN AN
ELECTRICITY COGENERATION PROJECT
FINANCING DEAL. THE PROJECT’S
SPONSORS WERE UNABLE TO OBTAIN
FIXED-RATE FINANCING ON
REASONABLE TERMS, AND THEY WERE
AFRAID THAT INTEREST RATES WOULD
INCREASE AND MAKE THE PROJECT
UNPROFITABLE.
 18.8D
COMMODITY
PRICE
EXPOSURE

 SUPPOSE THAT IN MID-AUGUST

FUTURES MARKET WERE 2017, PORTER FORESAW A NEED
FOR 100,000 POUNDS OF COPPER
ESTABLISHED FOR MANY IN MAY 2018 FOR USE IN
COMMODITIES LONG BEFORE FULFILLING A FIXED-PRICE
CONTRACT TO SUPPLY SOLAR
THEY BEGAN TO BE USED POWER CELLS TO THE U.S
FOR FINANCIAL GOVERNMENT.
MANAGERS ARE
PORTER’S
CONCERNED
INSTRUMENTS. THAT A STRIKE BY CHILEAN
COPPER MINERS WILL OCCUR,
WHICH COULD RAISE THE PRICE
OF COPPER IN WORLD MARKETS
AND TURN THE EXPECTED
PROFIT ON THE SOLAR CELLS
INTO A LOSS.
PORTER COULD, OF COURSE, BUY THE COPPER IT WILL NEED TO FULFIL THE
CONTRACT, BUT IF IT DOES, IT WILL INCUR SUBSTANTIAL CARRYING COSTS
The Chicago Mercantile Exchange trades standard copper
futures contracts of 25,000 pounds each. Thus, Porter could
buy four contracts (go long) for delivery in May 2018. These
contracts were trading in mid-August for $2.9895 per pound
and the spot price at that date was $2.9380 per pound. If
copper price continue to rise appreciably over the next 9
months, the value of Porter’s long position in copper futures
will increase, thus offsetting some of the price increase in
the commodity. Of course, if copper price fall, Porter will lose
money on its future contracts. But the company will be
buying the copper on the spot market at a cheaper price, so
it will make a higher than anticipated profit on its sale of
solar cells
MANY OTHER MANUFACTURERS, SUCH AS
ALCOA WITH ALUMINIUM AND ARCHER
DANIELS MIDLAND WITH GRAINS,
ROUTINELY USE THE FUTURES MARKETS
TO REDUCE THE RISKS ASSOCIATED WITH
INPUT PRICE VOLATILITY.
18.8E THE USE AND
MISUSE OF
DERIVATIVES
 MOST OF THE NEWS STORIES
ABOUT DERIVATIVES ARE
RELATED TO FINANCIAL
DISASTERS. MUCH LESS IS HEARD
ABOUT THE BENEFITS OF
DERIVATIVES.
In today’s market, sophisticated investors and analysts are
demanding that firms use derivatives to hedge certain risks.
So, if a company can safety and inexpensively hedge its
risks, it should do so.

There can, however, be a downside to the use of derivatives.

Hedging is invariably cited by authorities as a “good” use of
derivatives, whereas speculating with derivatives is often
cited as “bad” use.
Most would agree that the typical corporation should use
derivatives only to hedge risks, not to speculate in an
effort to increase profits. Recall from opening vignette to
this chapter that in its annual report, Procter & Gamble
indicated that it used derivatives to hedge its various risks.
It specifically stressed that it did not use derivatives for
speculative purposes. Hedging allows managers to
concentrate on running their core businesses without
having to worry about interest rate, currency, and
commodity price variability.
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