j. k. dietrich - fbe 432 – spring, 2002 module iii: practical issues and value creation using...

J. K. Dietrich - FBE 432 – Spring, 2002

Module III: Practical Issues and Value Creation Using

DerivativesWeek 9 – October 21 and 23, 2002


Session Outline

Complete discussions from Weeks 7 and 8 concerning interest-rate risk management

Outline some points to consider in Union Carbide case

Discuss some recent examples of problems using derivatives


Factor Model Risk Measures

The general factor model expresses the portfolio (or firm) returns (or cash flows) as a linear function of a number of factors

Example: the familiar CAPM market model is a single-factor model– The stock’s return is expressed as a linear

function of the market factor– But many industrial firms and banks are also

exposed to significant interest rate risk


Stylized Example

Suppose Citibank’s cash flows are negatively related to interest rate movements but increase with the Yen/$ rate. DefineC = cash flow, millions of U.S. dollars a month

Fcurr = the percentage change in the Yen/$ exchange rate, monthly

Fint = the change in LIBOR, monthly


Regression Measuring Risk The firm estimates a two-factor model

(using regression analysis) of the form:

The term represents idiosyncratic or unsystematic risks and the coefficients are the factor loadings

Sign (positive or negative) indicates whether firm has long or short exposure to risk (but be careful with interest rates)

int2curr10 FFC


Hedging Balance Sheet Risk Hedging on balance sheet

– Assets and liabilities chosen to offset risks– Changing mismatches of assets and/or

liabilities through swaps– Floating rate securities with short re-pricing

intervals have little interest-rate risk (low duration)

Hedging off balance sheet– Futures, forward contracts, and options


Balance Sheet Hedges

Example: United Airlines receives income in Canadian dollars from its operations in Canada

In 1997-98, the Canadian dollar depreciated against the US Dollar.

How can United hedge its currency risk from Canadian operations?


Balance Sheet Hedge Consider taking a long-term liability in

Canadian dollars to offset the (risky) income in Canadian dollars from UAL’s operations in Canada– A bank loan or bond issue (in Canada or

Eurobonds denominated in Canadian dollars), generates cash which can be converted to US dollars

– Interest obligations are met from Canadian income


Balance Sheet Hedge

Income in Canada

Canadian Dollar Liability

Initial Cash Inflow is converted to US Dollars


Swaps

Exchange of future cash flows based on movement of some asset or price– Interest rates– Exchange rates– Commodity prices or other contingencies

Swaps are all over-the-counter contracts Two contracting entities are called counter-parties Financial institution can take both sides


Interest Rate Swap:Plain vanilla, [email protected]%

Company A(receive floating)

Company B(receive fixed)

Notional Amount$100 mm

$2.75mm

1/2 5% fixed

1/2 6-month LIBOR

$2.5mm


Example: Interest Rate Swap

Two companies want to borrow $10 million with a 5 year duration

Company A, a financial institution, can borrow at fixed rate of 10%; B can borrow at a 11.2% fixed rate

Company A can borrow at a floating rate of 6 month LIBOR + 0.3%; B can borrow at a floating rate of 6 month LIBOR + 1%


Comparative Advantage

A: 10% LIBOR + 0.3%

B: 11.2% LIBOR + 1%

Fixed Floating

1.2% 0.7%Difference


Preferences

Company A prefers floating interest debt while B wants to lock in a fixed rate

However, A has a comparative advantage in the fixed rate market while B has a comparative advantage in the floating rate market


Swap Mechanics

Suppose A borrows at 10% fixed and B borrows at LIBOR + 1%, and then the two companies swap flows

Company A pays B interest at 6-month LIBOR on $10 million

Company B pays A interest at 9.95% per annum on $10 million


Interest Rate Swap

A B

LIBOR

9.95%10

%

LIBOR+1%


Both Parties are Better Off

Cost to A:– 10% to outside bank - 9.95% from B + LIBOR

= LIBOR + 0.05%– Cost saving is 25 basis points per year

Cost to B:– LIBOR + 1% to outside bank - LIBOR from A

+ 9.95% to A = 10.95%– Cost saving is 25 basis points per year


Swaps: Some fine points

The source of the gain is the fact that the two firms have different comparative advantages; even though A has an absolute advantage, there are still gains from trade

The total gain is 0.25% + 0.25% = 0.5% = 1.2% - 0.7%, the difference in the relative borrowing costs


Swaps in Practice

Note that a swap does not involve the exchange of principals– All that is swapped is the cash flows

To guard against default, the deal will typically be structured with an intermediary (usually a large bank) between the two parties


Swap: Bank Intermediary

A B

LIBOR

9.95%10%

LIBOR+1%

Bank

Even with fees, both parties are still better off

LIBOR- 0.05%

9.90%

Bank fees are 0.1%


Swaps in Practice

The intermediary will charge fees for acting as a clearing house and guaranteeing the payments

As long as these fees are below 0.5%, all parties can be made better off

If the deal is put together by the intermediary, it is not necessary for either firm to know the trade counter-party


Swaps in Practice

Many interest rate swaps also involve currency swaps or commodity swaps

Recently, the swap market has grown so rapidly that dealers will act as counterparties


Dealer Quotations for Swaps Example:

– IBM can issue fixed rate bonds at 7.0% per annum. IBM wants a floating rate obligation believing rates will fall.

– An OTC dealer gives IBM a fixed rate quote of 60 basis points over treasuries to be exchanged for 6-month LIBOR on a 5 year swap

– If 5-year treasuries are at 5.53%, this quote means that you can get 6-month LIBOR by paying 6.13% (= 5.53% +0.60) fixed rate.

– In IBM’s case, it would thus get 6.13% from the counterparty (or dealer) and would have to pay 6-month LIBOR, plus the 7.0% on its original debt

– All-in costs are approximately LIBOR+ 0.87%


The Value of Swaps

Swaps are beneficial because they allow hedging with one contract since they typically involve cash flows over several years

There are no losers; financial engineering results in value creation

The source of this value is in overcoming segmented markets


Interest-Rate Derivatives Interest rates and asset values move in opposite

directions Long cash means short assets Short cash means long (someone else’s) asset Basis risk comes from spreads between

exposure and hedge instrument, e.g. default risk premiums

Problem with production risk, e.g. interest rates up, needs for funds may be down with slowdown


Caps, floors, and collars

If a borrower has a loan commitment with a cap (maximum rate), this is the same as a put option on a note

If at the same time, a borrower commits to pay a floor or minimum rate, this is the same as writing a call

A collar is a cap and a floor


Collars: Cap 6%, floor 4%

Profit

0

Loss

9400 9500 9600


Other option developments

Credit risk options Casualty risk options Requirements for developing an option

– Interest

– Calculable payoffs

– Enforceable


Replication Futures with Options

P0 P0

LongProfit

Loss

0 0

Profit

Loss

Buy Call

Write Put


Short and Long Treasury Rates

0

4

8

12

16

20

55 60 65 70 75 80 85 90 95

TBILL3MO UST20YR UST30YR

3-Month and Long-Term (20 or 30 Yr) Treasuries

Source: FRB St. Louis


Treasury Rates since 1970

0

4

8

12

16

20

80 82 84 86 88 90 92 94 96 98

TBILL3MOUST20YRUST30YR

TBILL6MOUST5YRUST10YR

UST1YR

Term Structure of Treasures since 1970


Orange County, November, 1994

Citron bet on the yield curve and short-term rates staying low– Advised by investment bankers– “Leveraged” bet by

» Structured notes (inverse floaters)

» Borrowing using reverse repos

Duration mis-measured– Short-term portfolio (e.g. T-Bills) roughly .25– Orange County duration raised to around 7


Metall Gesellschaft

American unit of German company hedged short oil position– Strategy theoretically sound, as illustrated in

Merton Miller article– Problem in required size of position– Analog in GM case for five-year note would be

5 times $400 million or $2 billion in futures Hedging assumes markets are liquid and

prices are valid


Long-Term Capital Management

LTCM’s strategy depended on using arbitrage (risk-free buying and selling of assets) to make profits from temporary pricing anomalies

Used derivatives (e.g. futures and forwards, options, etc.) to arbitrage pricing of– European bond yields, expected to converge– 30-year versus 29+year U.S. Treasuries– Russian and junk bonds


Arbitrage and Derivative Prices

Markets are assumed to be liquid and mostly efficient

Prices are assumed to be good for large transactions

Arbitrage position can be closed or off-set at equilibrium values

Market imperfections are reality– Russian and global liquidity collapse in 1998– Stock market crash of 1987 and derivatives


Derivatives: Summary

Derivatives have been an important and beneficial expansion of financial markets– Allow better risk management– Enables more explicit pricing of risks/returns

Assumptions used to price derivatives are not always satisfied in the market-place

Government often steps in to change the rules and incentives for players in the “game”


Next -- October 28 & 30, 2002 Midterm discussed Review RWJ, Chapters 6 and 7, for next

class Read and think about issues in Financing

PPL Corporation’s Growth Strategy case

j. k. dietrich - fbe 432 – spring, 2002 module iii: practical issues and value creation using...

Documents

canada u

dietrich fbe

rate risk slide

rate risk management

balance sheet hedge

factor model risk measures

canadian income slide

canadian dollars