JEM034 Corporate Finance Winter Semester 2017/2018

Transcription

1 JEM034 Corporate Finance Winter Semester 2017/2018 Lecture #7 Olga Bychkova

2 Topics Covered Today Risk Management (chapter 26 in BMA) Hedging with Forwards and Futures Futures and Spot Contracts Swaps Hedging

3 Risk management Managers are paid to take risks, but not just any risks. Hedging risk can make sense if practical and if it reduces the chance of financial shortfall or distress. It could also by eliminating risks outside of manager control make it easier to monitor and motivate managers on what can be controlled. Why risk reduction may not add value 1. Hedging is a zero sum game 2. Investors do it yourself alternative

4 Risk Reduction Risks to a business Cash shortfalls Financial distress Agency costs Variable costs Currency fluctuations Political instability Weather changes

5 Hedging with Forwards and Futures Example: Kellogg produces cereal. A major component and cost factor is sugar. Forecasted income & sales volume is set by using a fixed selling price. Changes in cost can impact these forecasts. To fix your sugar costs, you would ideally like to purchase all your sugar today, since you like today s price, and made your forecasts based on it. But, you can not. You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today. This contract is called a Futures Contract. This technique of managing your sugar costs is called hedging.

6 Hedging with Forwards and Futures 1. Spot Contract A contract for immediate sale & delivery of an asset. 2. Forward Contract A contract between two people for the delivery of an asset at a negotiated price on a set date in the future. 3. Futures Contract A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract. The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & provides a secondary market for the speculation of Futures.

7 Types of Futures Commodity Futures Sugar Corn Wheat Soy beans Pork bellies Financial Futures T bills Yen Stocks Eurodollars Index Futures S&P 500 Value Line Index Vanguard Index

8 Futures Contract Concepts Not an actual sale Always a winner & a loser (unlike stocks) Settled every day (Marked to Market) Hedge used to eliminate risk by locking in prices Speculation used to gamble Margin not a sale post partial amount

9 Futures and Spot Contracts The basic relationship between futures prices and spot prices for equity securities: F t = S 0 (1 + r f y) t, where F t = futures price on contract of length t, S 0 = today s spot price, r f = risk free rate, y = dividend yield.

10 Futures and Spot Contracts Example: The DAX spot price is $3, The interest rate is 3% and the dividend yield on the DAX index is 2%. What is the expected price of the 6 month DAX futures contract? F t = S 0 (1 + r f y) t = $3, 890.1( ) = $4, 000.

11 Futures and Spot Contracts The basic relationship between futures prices and spot prices for commodities: F t = S 0 (1 + r f + sc cy) t, where F t = futures price on contract of length t, S 0 = today s spot price, r f = risk free rate, cy = convenience yield, sc = storage cost, ncy = cy sc = net convenience yield.

12 Futures and Spot Contracts Example: In January the spot price for oil was $41.68 barrel. The interest rate was 0.44 % per year. Given a one year futures price of $58.73, what was the net convenience yield? F t = S 0 (1 + r f + sc cy) t = 41.68( ncy) ncy = or 40.5%

13 Swaps Swap An agreement between two firms, in which each firm agrees to exchange the interest rate characteristics of two different financial instruments of identical principal.

14 Hedging: Set Up Find two closely related assets, then buy one and sell the other in proportions that minimize the risk of the net position. If perfectly correlated risk free net position. If not, we have some basis risk. The hedge ratio (delta) needs to be determined past movement of prices use theory, e.g., bond duration and implied sensitivity to interest rate changes

15 Margin The amount (percentage) of a Futures Contract Value that must be on deposit with a broker. Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to open a position = margin.

16 Risk Management: Problem 22, Chapter 26 of BMA Textbook Securities A, B, and C have the following cash flows: (a) Calculate their durations if the interest rate is 8%. (b) Suppose that you have an investment of $10 million in A. What combination of B and C would immunize this investment against interest rate changes? (c) Now suppose that you have a $10 million investment in B. How would you immunize? Duration = 1 PV (PV (C 1) 1 + PV (C 2 ) 2 + PV (C 3 ) 3)

17 Risk Management: Problem 22, Chapter 26 of BMA Textbook (a) For Security A: PV A = = $ Duration A = 1 ( ) = 1.95 years For Security B: PV B = = $ Duration B = 1 ( ) = 1 year For Security C: PV C = = $ Duration C = 1 ( ) = 2.74 years

18 Risk Management: Problem 22, Chapter 26 of BMA Textbook (b) Duration A = X Duration B + (1 X) Duration C 1.95 = X 1+(1 X) 2.74 X = and 1 X = Therefore, the following position would immunize the investment: a short position of $4,540,000 in Security B and a short position of $5,460,000 in Security C. (c) Duration B = X Duration A + (1 X) Duration C 1 = X 1.95+(1 X) 2.74 X = and 1 X = Therefore, the following position would immunize the investment: a short position of $22,030,000 in Security A and a long position of $12,030,000 in Security C.

19 Risk Management: Problem 26, Chapter 26 of BMA Textbook Price changes of two gold mining stocks have shown strong positive correlation. Their historical relationship is Average percentage change in A = percentage change in B Changes in B explain 60% of the variation of the changes in A (R 2 = 0.6). (a) Suppose you own $100,000 of A. How much of B should you sell to minimize the risk of your net position? (b) What is the hedge ratio? (c) Here is the historical relationship between stock A and gold prices: Average percentage change in A = = percentage change in gold price If R 2 = 0.5, can you lower the risk of your net position by hedging with gold (or gold futures) rather than with stock B? Explain.

20 Risk Management: Problem 26, Chapter 26 of BMA Textbook (a) 0.75 $100, 000 = $75, 000 (b) δ = 0.75 (c) You could sell 1.2 $100, 000 = $120, 000 of gold (or gold futures) to hedge your position. However, since the R 2 is less (0.5 versus 0.6 for Stock B), you would be less well hedged.

21 Risk Management: Problem 33, Chapter 26 of BMA Textbook Phillip s Screwdriver Company has borrowed $20 million from a bank at a floating interest rate of 2 percentage points above three month Treasury bills, which now yield 5%. Assume that interest payments are made quarterly and that the entire principal of the loan is repaid after five years. Phillip s wants to convert the bank loan to fixed rate debt. It could have issued a fixed rate five year note at a yield to maturity of 9%. Such a note would now trade at par. The five-y-ear Treasury note s yield to maturity is 7%. (a) Is Phillip s stupid to want long term debt at an interest rate of 9%? It is borrowing from the bank at 7%. (b) Explain how the conversion could be carried out by an interest rate swap. What will be the initial terms of the swap? (Ignore transaction costs and the swap dealer s profit.)

22 Risk Management: Problem 33, Chapter 26 of BMA Textbook One year from now short and medium term Treasury yields decrease to 6%, so the term structure then is flat. (The changes actually occur in month 5.) Phillip s credit standing is unchanged; it can still borrow at 2 percentage points over Treasury rates. (c) What net swap payment will Phillip s make or receive? (d) Suppose that Phillip s now wants to cancel the swap. How much would it need to pay the swap dealer? Or would the dealer pay Phillip s? Explain.

23 Risk Management: Problem 33, Chapter 26 of BMA Textbook (a) Phillip s is not necessarily stupid. The company simply wants to eliminate interest rate risk. (b) The initial terms of the swap (ignoring transactions costs and the dealer s profit) will be such that the net present value of the transaction is zero. Phillip s will borrow $20 million for five years at a fixed rate of 9% and simultaneously lend $20 million at a floating rate two percentage points above the three month Treasury bill rate which is currently a rate of 7%. (c) Under the terms of the swap agreement, Phillip s is obligated to pay $0.45 million per quarter ($20 million at 2.25% per quarter) and, in turn, receives $0.4 million per quarter ($20 million at 2% per quarter). That is, Phillip s has a net swap payment of $0.05 million per quarter.

24 Risk Management: Problem 33, Chapter 26 of BMA Textbook (d) Long term rates have decreased, so the present value of Phillip s long term borrowing has increased. Thus, in order to cancel the swap, Phillip s will have to pay the dealer. The amount paid is the difference between the present values of the two positions: The present value of the borrowed money is the present value of $0.45 million per quarter for 16 quarters, plus $20 million at quarter 16, evaluated at 2% per quarter (8% annual rate, or two percentage points over the long term Treasury rate). This present value is $20.68 million. The present value of the lent money is the present value of $0.4 million per quarter for 16 quarters, plus $20 million at quarter 16, evaluated at 2% per quarter. This present value is $20 million, as we would expect. Because the rate floats, the present value does not change. Thus, the amount that must be paid to cancel the swap is $0.68 million.