Module III: Practical Issues and Value Creation Using Derivatives

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Module III Practical Issues and Value Creation
Using Derivatives

• Week 9 October 21 and 23, 2002

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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

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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 stocks 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

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Stylized Example

• Suppose Citibanks cash flows are negatively
  related to interest rate movements but increase
  with the Yen/ rate. Define
• C 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

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Regression Measuring Risk

• The firm estimates a two-factor model (using
  regression analysis) of the form
• The term e 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)

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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

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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?

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Balance Sheet Hedge

• Consider taking a long-term liability in Canadian
  dollars to offset the (risky) income in Canadian
  dollars from UALs 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

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Balance Sheet Hedge
Income in Canada
Initial Cash Inflow is converted to US Dollars
Canadian Dollar Liability
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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

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Interest Rate SwapPlain vanilla, LIBOR_at_5.5
1/2 5 fixed
Company A (receive floating)
Company B (receive fixed)
2.5mm
2.75mm
1/2 6-month LIBOR
Notional Amount 100 mm
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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

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Comparative Advantage
Fixed Floating
A 10 LIBOR 0.3
B 11.2 LIBOR 1
Difference
1.2 0.7
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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

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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

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Interest Rate Swap
LIBOR1
9.95
A
B
10
LIBOR
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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

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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

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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

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Swap Bank Intermediary
Bank fees are 0.1
LIBOR1
A
B
9.95
Bank
9.90
10
LIBOR
LIBOR- 0.05
Even with fees, both parties are still better off
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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

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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

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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 IBMs 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

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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

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Interest-Rate Derivatives

• Interest rates and asset values move in opposite
  directions
• Long cash means short assets
• Short cash means long (someone elses) 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

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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

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Collars Cap 6, floor 4

• Profit

0
9400
9500
9600
Loss
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Other option developments

• Credit risk options
• Casualty risk options
• Requirements for developing an option
• Interest
• Calculable payoffs
• Enforceable

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Replication Futures with Options
Profit
Profit
Buy Call
Long
0
0
P0
P0
Loss
Loss
Write Put
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Short and Long Treasury Rates
Source FRB St. Louis
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Treasury Rates since 1970
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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

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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

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Long-Term Capital Management

• LTCMs 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 29year U.S. Treasuries
• Russian and junk bonds

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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

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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

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Next -- October 28 30, 2002

• Midterm discussed
• Review RWJ, Chapters 6 and 7, for next class
• Read and think about issues in Financing PPL
  Corporations Growth Strategy case