Managing Financial Risk with Forwards, Futures, Options, and Swaps. Second Edition

Managing Financial Risk with Forwards, Futures, Options, and Swaps Second Edition

Managing Financial Risk with Forwards, Futures, Options, and Swaps Second Edition Fred R. Kaen

Contents About This Course How to Take This Course xi xiii 1 Financial Risk Management 1 What Is Financial Risk? Commodity Price Risk Interest Rate Risk Interest Rate Risk, Bond Yields, and Bond Prices Currency Risk (Foreign Exchange Rate Risk) Risk Management at Quaker Oats A Theoretical Perspective on Risk Management From Theory to Practice: Why Firms Should Manage Risk Reducing Financial Distress and Bankruptcy Costs Using Risk Management to Lower Taxes Using Risk Management to Control Stakeholders Costs and Protect Undiversified Owners Using Risk Management to Control Managers and Reduce Conflicts of Interest between Managers and Shareholders Using Risk Management to Improve Decision Making and Capital Budgeting 2 Measuring Risk Exposure 19 Volatility The Mean and Expected Value The Variance and Standard Deviation Continuous Probability Distributions and the Normal Curve Factor Betas Value at Risk and Cash Flow at Risk A CaR Calculation

Qualifications and Warnings The Usefulness of VaR and CaR Simulation 3 Interest Rate Risk Management Issues 39 The Term Structure of Interest Rates The Expectations Theory Liquidity Preference Theory Preferred Habitat Theory Duration The Dollar Value of a One Basis Point Decrease (DV01) Immunization 4 Managing Risk with Forward Contracts 55 Forward Contracts The Foreign-Exchange Forward Contract The Forward Exchange-Rate Market The Term Structure of Forward Exchange Rates Covered Interest Rate Parity Forward Rate Premiums and Discounts Using Forward Exchange-Rate Contracts to Manage Exchange-Rate Risk Replicating a Foreign-Exchange Forward Contract through Borrowing and Lending Forward Rate Agreements Forward Exchange-Rate Agreements (FXAs) Commodity Forward Contracts 5 Managing Risk with Futures Contracts 73 The Futures Contract The Mechanics of Futures Contracts Trading Marking-to-Market The Clearinghouse Price Limits

Using Foreign Exchange Futures Covering an Underlying Short Foreign Currency Position Covering an Underlying Long Foreign Currency Position Basis and Maturity Mismatches Basis Quantity Mismatches Interest-Rate Futures IMM Eurodollar Futures Contracts Using Interest-Rate Futures to Lock in Lending Rates Using Interest-Rate Futures to Lock in Borrowing Rates Other Hedging Possibilities The Pricing of Financial Futures Contracts Backwardation, Contango, and Convergence Commodity Futures Futures versus Forwards 6 Options: Terminology and Principles 95 Option Terminology and Overview Valuing a European Call Option Using Common Stock and Borrowing to Value European Call Options Riskless Arbitrage Price Spreads, Interest Rates, and Maturity The Black-Scholes Model Stock or Asset Price, S Exercise Price, X Standard Deviation of Asset Returns or Asset Price, s Risk-Free Interest Rate, r Time to Expiration, t The Hedge Ratio, N(d1) Using the Black-Scholes Option Pricing Model: Valuing Call Options Using the Black-Scholes Option Pricing Model: Valuing Put Options The Black-Scholes Assumptions 7 Managing Risk with Options 113 Foreign Currency Options Foreign Currency Spot Options Hedging Expected Foreign Currency Payments with Spot Currency Options Hedging Expected Foreign Currency Receipts with Spot Currency Options Foreign Currency Futures Options

Interest Rate Options Using Interest Rate Options to Set Interest Rate Borrowing Caps Choosing a Different Strike Price Comparison of an Options Hedge with a Futures Hedge Using Interest Rate Options to Set Floors on Lending Rates Why Options on Futures Contracts and Not Cash Markets? Commodity Options Using Commodity Call Options to Hedge Commodity Purchase Prices Using Commodity Put Options to Hedge Commodity Selling Prices Which Strike Price? Writing Options 8 Managing Risk with Swaps 131 Interest Rate Swaps The Rationale for Interest Rate Swap The Basic Interest Rate Swap Market Conventions Currency Swaps A Stylized Currency Swap Swap Quotes and Calculating the All-In Cost of a Swap The Rationale for Currency Swaps Commodity Swaps Swap Variations The Risks of Swaps 9 Financial Engineering 149 The Building Blocks The Unhedged or Open Position The Forward and Futures Contract Option Contracts Setting Caps and Floors: Foreign Exchange Rates Caps and Floors: Interest Rates Synthetic Fixed-Rate Loans Synthetic Loans with Interest Rate Options Structured Notes Index-Amortizing Notes Range Notes Exotic Options

10 Corporate Strategy and Risk Management 163 Who Does and Does Not Hedge? Who Should Hedge and When? Organizing the Risk Management Function Glossary Risk Management and You: Hints, Suggestions, and Some Answers Bibliography Post-test Index 175 189 195 197 207