Chapter 25

Hedging with
Financial
Derivatives

Chapter Preview
We examine how markets for derivatives work
and how the products are used by financial
managers to reduce risk. Topics include:
Hedging
Forward Markets
Financial Futures Markets
Stock Index Futures
Predicting the Fed Funds Rate

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-2

Hedging
Hedging involves engaging in a financial
transaction to offset an existing position to
reduces or eliminate risk.
Definitions
long position: an asset which is purchased
or owned
short position: an asset which must be delivered at a
future date, or an asset which is borrowed and sold,
but must be replaced in the future

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-3

Forward Markets
Forward contracts are agreements by two
parties to engage in a financial transaction at a
future point in time.
The contract usually includes:
The exact assets to be delivered by one party,
including the location of delivery
The price paid for the assets by the other party
The date when the assets and cash will be exchanged

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-4

Forward Markets
An Example of an Interest-Rate Contract
First National Bank agrees to deliver $5 million
in face value of 6% Treasury bonds maturing
in 2027
Rock Solid Insurance Company agrees to pay
$5 million for the bonds
FNB and Rock Solid agree to complete the
transaction one year from today at the FNB
headquarters in town.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-5

Hedging Long or Short?

Quiz: Suppose you work for a business

whose expects to receive $15 million

from a client next year. You are worried
that interest rates are going to fall next
year as the US economy slows.
How would you hedge against the
interest rate risk your company faces?

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-6

Hedging Long or Short?

A: You take a long position in bonds to offset
your existing long position in cashengage in a
Forward Contract to buy $15 million in bonds at
a fixed price.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-7

Forward Markets
Long Position
Agree to accept delivery of securities at future date
subject to terms of forward contract.
Hedges by locking in future interest rate of funds
coming in future, avoiding rate decreases.

Short Position
Agree to deliver securities at future date subject to
terms of forward contract
Hedges by reducing price risk from increases in
interest rates if holding bonds.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-8

Forward Markets
Pros
1. Flexible

Cons
1. Lack of liquidity: hard to find a counter-party and thin
or non-existent secondary market
2. Subject to default riskrequires information to screen
good from bad risk
3. Adverse selection and moral hazard problems.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-9

Financial Futures Markets

Financial futures contracts are highly
standardized forward contracts traded on
organized exchanges subject to specific
rules.
Traded on Exchanges
Developed by Chicago Board of Trade in 1975 to
solve liquidity and default problems of forward
contracts. Global competition Regulated by CFTC.
Commodity Futures Options Trading, Inc. home page
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

http://www.cbot.com

25-10

Financial Futures Markets

Financial Futures Contracts Specify

1.
2.
3.
4.
5.

Type of security to be traded

Delivery Location
Amount to be Delivered
Date
Price

Success of FFC
1. FFC are more liquid: standardized contracts that can be traded
2. Delivery of range of securities reduces the chance of corner.
3. Mark to market daily: avoids default risk
4. Don't have to deliver: cash netting of positions

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-11

Financial Futures Markets

Delivery?
1. If the position remains open until the delivery date, then shorts
must deliver and longs must accept delivery of underlying
asset.
2. But before the delivery date, positions can be closed by taking
the opposite position.
Delivery occurs in about 3% of T-bond and T-note contracts.

Profit or Lossnote that when the price of the futures

contract rises, investors with a long position gain, and
short positions loose.

Commodity Futures Options Trading, Inc. home page

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

http://www.cbot.com

25-12

30 Year U.S. Treasury Bonds Futures

Contract Size

One U.S. Treasury bond having a face value at maturity of $100,000 or multiple thereof.

Deliverable Grades

U.S. Treasury bonds that, if callable, are not callable for at least 15 years from the first day of the
delivery month or, if not callable, have a maturity of at least 15 years from the first day
of the delivery month. The invoice price based on 6% standard.

Price Quote

Points ($1,000) and thirty-seconds of a point; for example, 80-16 equals 80 16/32

Contract Months

Mar, Jun, Sep, Dec

Last Trading Day

Seventh business day preceding the last business day of the delivery month. Trading in expiring
contracts closes at noon, Chicago time, on the last trading day.

Last Delivery Day

Last business day of the delivery month.

Trading Hours

Open Auction: 7:20 am - 2:00 pm, Chicago time, Monday - Friday

Electronic: 6:00 pm - 4:00 pm, Chicago time, Sunday - Friday
Trading in expiring contracts closes at noon, Chicago time, on the last trading day

Ticker Symbols

Open Auction: US; Electronic: ZB

Daily Price Limit

None

Margin Information

Find information on margins requirements for the 30 Year U.S. Treasury Bond

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-13

Financial Futures Markets

Trading

Your broker contacts floor trader who executes purchase or

sale of futures contract
Trades are effectively with the exchange's clearinghouse acting
as a counterparty in each trade. There must be a short position
for each long position.
All trades require a Margin Deposit.

Initial Margin is set by the exchange for each contract type

End of trading day settlement price on contract is determined
Each open account is marked to market. If P , long position
profits and short position loses.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-14

Financial Futures Markets

Example of long position in January 8 crude oil at $90 per
barrel (1,000 barrel contract). http://www.nymex.com/WS_spec.aspx
Date

Settlement
Price

Nov. 1

$90

Nov. 2

$96.0

Nov. 3

Deposit or
Withdrawl

Margin
Balance

$7,763

$7,763

6.0

$6,000

$13,763

$86.00

-10.0

-$10,000
+1,987

$3,763
$5,750

Nov. 29

$88.00

+2

$2,000

$7,750

Nov. 29

$88.00

Close with
short

-7,750

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

Mark to Market

25-15

Financial Futures Markets

Pricing
Arbitrage insures that settlement price on FFC
and expected Spot Price should move together.
At Settlement Date, price of contract = price of
the underlying asset delivered.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-16

T-Bond Financial Futures

Contractfordeliveryof$100,000FaceValueofTreasurybondfromWSJ
11/30/00.Contractspecifies#ofyearstomaturityleftonthebond.
Openopeningprice,101*$1000+(25/32)*$1000=$101,781.25
High/Low,Settle=finalpriceofday.
OpenInterest=151,728*$100,000=$152billion
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-17

Widely Traded Financial

Futures Contracts

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-18

Widely Traded Financial

Futures Contracts

esoteric futures
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-19

Predicting Fed Behavior

Using Fed Funds Futures

The Chicago Board of Trade lists future contracts

on the Fed Fund rates.
The long position (agrees to take delivery) will
receive the interest that would be paid on $5
million of fed funds held for 30 days. The short
position will deliver that amount.
The price of the contract is 100 minus the average
Fed Funds rate during the contract month.
The Fed funds contract for Dec. (Exp. Date Jan 2,
2008) is currently selling for 95.78, so the average
fed funds rate for the month of Dec. is expected to
be 100-95.78, or 4.22%.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-30

Fed Funds Futures

Trading Unit

$5 million.

Price Quote

100 minus the average daily effective fed funds rate for the delivery month.

Settlement
The contract is cash settled against the average daily effective
fed funds rate for the delivery month.
Contract Months

First 24 consecutive calendar months.

Last Trading Day

Last business day of the delivery month.

Ticker Symbols

Open Outcry: FF

Daily Price Limit

None

Note that during an expiration month, the price for the current contract
reflects the weighted average of two key components:
1. The realized overnight effective fed funds rates experienced to date
2. The expected effective ffs rates to the end of the month.
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-31

Predicting Fed Behavior

Using Fed Funds Futures

The Fed funds contract for Dec. (Exp. Date Jan 2,

2008) is currently selling for 95.78, so the average
fed funds rate for the month of Dec. is expected to
be 100-95.78, or 4.22%.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-32

Price of Fed Funds Futures

Futures Price during the current month:

Where Daysn = number of days in the current month

j = number of days passed to date.
FERe is the expected Fed funds effective rate from j+1 to n.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-33

Price of Fed Funds Futures

Suppose on Nov. 9 the November contract was priced at

95.45, implying a rate of
4.56% = 100 - 95.44
The price of 95.44 reflects the average daily fed effective
rate for the first 9 days of November, 4.468, and an implied
expected fed effective rate for the remaining 21 days of
November of 4.59%.

Current
Fed Funds
Futures Rate

= 4.56% = (9/30) x 4.468 + (21/30) x ??

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-34

Predicting Fed Funds Rates

Lets try to figure out the probability for a 50 basis point
cut in the fed funds rate.
The current Fed Fund rate target is 4.5%.
QUIZ: If the Fed cuts the Fed Funds rate target by 50
basis points at its next meeting (Dec. 11), what
would the average fed funds rate be for the month of
Dec? What probability does the Fed Funds Mkt
assign to a 50 basis point cut?

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-35

Predicting Fed Funds Rates

Lets try to figure out the probabilities for a 50 basis point cut.
The Current Fed Fund rate target
fft = 4.5%.

The Fed Funds futures price implies a rate of

iffr = 100 - 95.78 = 4.22%.
The Implied Fed Funds futures rate (iffr) is what the futures market thinks
the fed funds rate will be on average for the month of Dec.

If the Fed changes the target rate after markets close on Dec. 11-next FOMC meeting, then the first 11 days of Dec will have a rate
of, ffr = fft = 4.5%.

The last 20 days will have a rate of 4.0% with probability p, and a
rate of 4.5% (no change) with probability (1 - p).

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-36

Predicting Fed Funds Rates

So the futures market thinks the average fed funds
rate for the month of May will be:
iffr

= oldfft x(11/31) + ffrex(20/31)

Where
ffre
= newfft x p + oldfft x(1- p)

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-37

Predicting Fed Funds Rates

Prob

is aprox

=
=
=

(ffir - oldfft)/(newfft - oldfft)

(4.22 - 4.5)/(4.0 - 4.5)

(-.28)/(-.5)
56%

http://stlouisfed.org/education/8fc/FC-econdata.html
Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-38

Chapter Summary
Hedging: the basic idea of entering into an
offsetting contract to reduce or eliminate
some type of risk was presented.
Forward Markets: the basic idea of
contracts in this highly specialized market,
as well as a simple example of eliminating
risk was presented.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-39

Chapter Summary (cont.)

Financial Futures Markets: these exchange
traded markets were presented, as well as
their advantages over forward contacts.
Stock Index Futures: the specific
application of stock index futures was
presented, exploring their ability to reduce
or eliminate risk for equity portfolios.

Copyright 2006 Pearson Addison-Wesley. All rights reserved.

25-40