1. © 2004 Pearson Addison-Wesley. All rights reserved 13-1 Hedging Hedge: engage in a financial transaction that reduces or eliminates risk Basic hedging principle: – Hedging risk: offset a long position (e.g., the value of a stock you hold) by taking a short position (e.g., a put option on the stock) offset a short position by taking an additional long position –If you lose on one, you gain on the other

2. © 2004 Pearson Addison-Wesley. All rights reserved 13-2 Instruments for Hedging (and Speculation) Forward contracts Futures contracts Options –Calls –Puts Swaps

3. © 2004 Pearson Addison-Wesley. All rights reserved 13-3 Interest-Rate Forward Markets Long position = agree to buy securities at future date Hedges by locking in future interest rate if you expect funds to come in future Short position = agree to sell securities at future date Hedges by reducing price risk from change in interest rates if you are already holding bonds Pros 1.Flexible Cons 1.Lack of liquidity: hard to find counterparty 2.Subject to default risk: requires information to screen good from bad risk

4. © 2004 Pearson Addison-Wesley. All rights reserved 13-4 Financial Futures Markets Financial Futures Contract 1.Specifies delivery of type of security at future date 2.Arbitrage  at expiration date, price of contract = price of the underlying asset delivered 3.i , long contract has loss, short contract has profit 4.Hedging similar to forwards Micro hedge using forwards vs. macro hedge using futures Traded on Exchanges: Global competition Regulated by CFTC Success of Futures Over Forwards 1.Futures more liquid: standardized, can be traded again, delivery of range of securities 2.Delivery of range of securities prevents corner 3.Mark to market and margin requirements: avoids default risk 4.Don’t have to deliver: netting

5. 13-5

6. 13-6

7. 13-7 Options Options Contract Right to buy (call option) or sell (put option) instrument at exercise (strike) price up until expiration date (American option) or on expiration date (European option) Hedging with Options Buy same # of put option contracts as you would sell futures Disadvantage: pay premium Advantage: protected if i , gain if i 

8. 13-8 Profits and Losses: Options vs. Futures $100,000 T-bond contract, 1. Exercise price of 115, $115,000. 2. Premium = $2,000

9. © 2004 Pearson Addison-Wesley. All rights reserved 13-9 Factors Affecting Option Premium 1.Higher strike price  lower premium on call options and higher premium on put options 2.Greater term to expiration  higher premiums for both call and put options 3.Greater price volatility of underlying instrument  higher premiums for both call and put options

10. © 2004 Pearson Addison-Wesley. All rights reserved 13-10 Interest-Rate Swap Contract 1.Notional principle of $1 million 2.Term of 10 years 3.Midwest SB swaps 7% payment for T-bill + 1% from Friendly Finance Co.

11. © 2004 Pearson Addison-Wesley. All rights reserved 13-11 Hedging with Interest-Rate Swaps Reduce interest-rate risk for both parties 1.Midwest converts $1m of fixed rate assets to rate-sensitive assets Midwest’s RSA  Reduces Midwest’s GAP between rate sensitive assets and rate sensitive liabilities 2.Friendly Finance: RSA , lowers Friend’s GAP between rate sensitive assets and liabilities Advantages of swaps 1.Reduce risk, no change in balance-sheet 2.Longer term than futures or options Disadvantages of swaps 1.Lack of liquidity 2.Subject to default risk Financial intermediaries help reduce disadvantages of swaps