Chapter 13

Managing Project Risks

Hedging

Use of financial instruments to reduce or
negate the risk by transferring the
exposure to another party
 Drop in price of the product
 Increase in interest rates
 Weakening of the home currency

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Derivatives

A financial instrument whose value
depends on (or derives from) the price of
some underlying quantity, such as a stock
price or an interest rate
 Swaps
 Options
 Forwards
 Futures

Swaps

A swap contract obligates two parties to
exchange specified cash flows at specified
intervals.

In an interest-rate swap, the cash flows are
determined by two different interest rates in the
same currency.

In a currency swap, the cash flows are based on
interest rates in two different currencies. The two
parties usually exchange the amounts of the
currencies on which the interest rates are based

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Interest Rate Swap

Exchange of interest payment obligations
 Exchange of coupon payments, not principals
 Notional principal amount
 Fixed-rate-floating-rate
 Floating-rate-floating-rate

Beneficial only if it is superior for each party to a straight
borrowing that is identical in design and risk.

Deferred-start interest-rate swap that will start on the
future date. The anticipated long-term floating-rate
financing for the project is put in place enables to fix the
interest cost before the long-term loan is even negotiated

Interest Rate Swap

LOAN PAY 8%
SWAP
LENDER BORROWER COUNTER
PARTY
PAY LIBOR+1% RECEIVE LIBOR

Net interest rate paid by the borrower is 9%

3
Value Added by Interest Rate Swaps

Credit Default Swap

Credit derivative is a privately negotiated contract the
value of which is derived from the credit risk of a bond, a
bank loan, or some other credit instrument.

Credit risk refers to the risk that a security will lose value
because of a reduction in the issuers capacity to make
payments of interest and principal. It refers to the
likelihood that the issuer will actually default, that is, fail
to make timely payments of principal and interest

A credit default swap (CDS) is a swap contract in which
the buyer of the CDS makes a series of payments to the
seller and, in exchange, receives a payoff if a credit
instrument - typically a bond or loan - goes into default
(fails to pay)

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How CDS Works?
t= 1 2 3 4 5 n
Buyer

Seller
t=0 n

Seller
t=0 n

Credit Insurance

CDS is form of credit insurance

Enable market participants to separate credit risk from
other types of risk

Value of a credit derivative is linked to the change in
credit quality of the specified underlying fixed-income
security, usually a bond, a note, or a bank loan

A deterioration (improvement) in credit quality raises
(lowers) the yield investors require and reduces
(increases) the price of the bond, other factors remaining
the same

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Hedging Credit Risk

Lenders and fixed-income investors can hedge
their credit risk exposure by purchasing a credit
swap linked to the loan

Project sponsors or lenders who are concerned
about their exposure to the sovereign credit risk
of the country in which the project is located can
buy a credit swap linked to the sovereign
issuers outstanding debt

Options

An option gives its holder the right to do something,
without the obligation to do it. An option is any right that
has no obligation attached to it.

A call option is the right to buy an asset. A call option
gives its holder the opportunity to benefit from good
outcomes.

A put option is the right to sell an asset. A put option
gives its holder the opportunity to avoid bad outcomes

The strike price is the price at which the option holder
may buy or sell the underlying asset when the option is
exercised.

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Options

When exercising an option would provide an advantage
over buying or selling the underlying asset in the open
market, the option is in-the-money

When exercising an option would not provide an
advantage over buying or selling the underlying asset
currently in the market, the option is out-of-the-money

The exercise value (also called intrinsic value) is the
amount of advantage an in-the-money option provides
over buying or selling the underlying asset currently in
the market.

An out-of-the-money option has a zero exercise value

Options

An options expiration is the point in time
the option contract ceases to exist.

An American option is an option that can
be exercised at any time prior to its
expiration.

A European option can be exercised only
at the end of the contract, not before.

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Call Option

Investor buys a European call option to
purchase 1 share of Googles stock at a
strike price of $400/share, three months
from today. Current spot price of Google
stock is $390/share. Option price
(premium) is $10/share.

Call Option

If spot price at expiration is less than $400,
option is not exercised and investor loses $10

If spot price at expiration is greater than $400,
option should be exercised. Suppose, spot price
at expiration is $420. Then, investor would
exercise the option, by purchasing one Google
share at $400, immediately selling it at spot price
and realizing a gain of $20. Taking into account
initial cost of an option, net profit is $10.

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 Pu
Call Option rch
cal aser o
hop l opt f
Profit es t io n a
p ha
30 un rice o t the
der fa
wil lying n
l in a
20 cre sset
ase
10

370 380 390 400 410 420 430

Terminal
-10
stock
price
-20

Put Option

Investor buys a European put option to sell
1 share of Googles stock at a strike price
of $400/share, three months from today.
Current spot price of Google stock is
$390/share. Option price (premium) is
$10/share.

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Put Option

If spot price at expiration is greater than
$400, option is not exercised and investor
loses $10

If spot price at expiration is less than $400,
option should be exercised. Suppose, spot
price at expiration is $380. Then, investor
would buy one share of Google stock on
the market, and exercise the option to sell
the same share for $400, realizing a gain
of $20. Taking into account initial cost of
an option, net profit is $10.

Put Option Pu
put rchas
e
tha option r of a
Profit t th hop
an e
30
und price es
asse erlyi of
t n
20 dec will g
r ea
se
10

370 380 390 400 410 420 430

Terminal
-10
stock
price
-20

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Option positions

Option buyer long position

Option seller (writer) short position

Types of option position
 Long position in a call option
 Long position in a put option
 Short position in a call option
 Short position in a put option

Long position in a call

Profit
30

20

10

370 380 390 400 410 420 430

Terminal
-10
stock
price
-20

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Long position in a put
Profit
30

20

10

370 380 390 400 410 420 430

Terminal
-10
stock
price
-20

Short position in a call

Profit
30

20

10

370 380 390 400 410 420 430

Terminal
-10
stock
price
-20

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Short position in a put
Profit
30

20

10

370 380 390 400 410 420 430

Terminal
-10
stock
price
-20

Option payoffs
LONG SHORT

C
A max (ST K; 0) min (K ST; 0)
L
L

P
U max (K ST; 0) min (ST K; 0)
T

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Option payoffs
LONG SHORT
Payoff Payoff
C
A K ST
L
L
K ST

Payoff Payoff
P
U K ST
T
K ST

Warrant

A long-term call option issued by a firm,
which entitles the holder to buy shares of
the firms common stock at a stated price
for cash.

Often included as a sweetener to a new
issue of common stock or a privately
placed debt issue

A covered call option, because its written
on un-issued stock

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Convertible Bond/Preferred Stock

Entitles the holder to exchange the bond

(or preferred share) for a stated number of
shares of the issuing firms common stock

Incorporates a warrant that lets the owner
profit if the firms share price goes up

Convertible Bonds

Have a coupon rate, maturity, and optional
redemption features just like a straight bond

Conversion price price at which a bond can be
exchanged for stock, usually exceeds the market
share price at the time of bond issue.

Conversion ratio - number of shares of common
stock into which each bond can be converted
Face amount of the convertible bond
Conversion price

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Convertible bonds

Conversion price is usually adjusted for
stock splits, stock dividends, rights
offerings, and asset distributions by
lowering the strike (offering) price

Accrued interest is not received, if bond is
converted

Value of a convertible bond

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Forward contract

A forward contract obligates the holder to buy a
specified amount of a particular asset at a stated
price on a particular date in the future. All terms
are fixed at the time the forward contract is
entered into

The specified future price is the exercise price
and its equal to the expected future price

Most forward contracts are for commodities or
currencies

Most forwards contracts require physical delivery
of an asset, although some can provide for cash
settlement

Gain/loss is realized on settlement date

Traded on over-the-counter (OTC) market

Forward contract example

Oil refinery enters into a forward contract with oil
producer, to purchase crude oil

Quantity: 10,000 barrels

Exercise price: $45/barrel

Maturity: 90 days

Total obligation: $450K

Market price of oil after 90 days:
 $50/barrel: Oil refinery realizes a profit of $50K
 $40/barrel: Oil refinery realized a loss of $50K

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Futures Contract

Similar to forward contract, except:
 Futures are traded on organized exchanges vs. OTC
 Gains/losses are realized daily

Underlying assets are agricultural commodities,
precious metals, industrial commodities,
currencies, stock market indexes, common
stocks, and interest-bearing securities, such as
T-bills, T-notes, T-bond, and Eurodollar deposits

Physical asset contracts require physical
delivery, currency/security contracts are cash-
settled

Futures Contract

Rarely held to maturity

Usually closed by reverse trading
 Long position in futures is closed, by selling
(shorting) an identical contract

Futures prices are limited by price change
limits, due to their high volatility

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Futures vs. Forwards

Futures have lower default risk
 Futures are marked-to-market and settled daily, any
loss realized during the day by holder is paid to seller
 Margin requirements both parties are required to
post a performance bond which is adjusted daily
 There is a clearinghouse. Each party to a futures
transaction really enters into a transaction with the
clearinghouse, not directly with each other

Futures are more liquid than forward contracts
 A standardized contract
 Trading on organized exchanges

Futures contract example

A T-bond futures contract

Underlying asset: $100,000 value bond, with 20-
year maturity and 8% coupon

Delivery in 6 months, at a price of 96
(percentage of face value, or $96,000)

If interest rates go up:
 Value of the bond goes down
 Value of the futures contract goes down
 Holder realizes a loss
 Seller realizes a gain

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Hedging

Hedging can be used to reduce the
projects sensitivity to changes in the price
of a commodity, a foreign exchange rate,
or an interest rate

Taking an offsetting position, by buying or
selling a financial instruments whose value
changes in the opposite direction from the
value of an asset being hedged

How a hedge works?

Value of the project

Value of the project

unhedged

Value of the project

hedged

Interest rates

Value of the hedge

position

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Hedging with options

Options provide an opportunity to hedge against
a bad outcome while preserving the opportunity
to benefit from a good outcome

An investor purchases 100 shares of Google at
$390/each, and wants to hedge against falling
prices

A hedge is formed by purchasing a put option

Strike price: $390/share

Option premium: $20/share

Hedging with options

8000 Gain/Loss
Gain/loss
Gain/loss
w/hedge
6000 on option

4000 Net
Gain/loss
2000

0
320 330 340 350 360 370 380 390 400 410 420 430 440 450 460
-2000 Stock Price

-4000

-6000
Gain/loss
-8000 on stock

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Interest Rate Cap

Call option on a floating exchange rate,
with a fixed cap (strike price)

Hedges against a rise in interest rates

Assume a $100 loan, with floating-rate
interest equal to LIBOR

An interest-rate cap with 8% cap is used to
hedge

Interest Rate Cap

$4.0

$2.0

$0.0
1 2 3 4 5 6 7 8 9 10 11 12 13
($2.0)
Interest payable
($4.0) Cap contract payment
Net interest payable
($6.0)

($8.0)

($10.0)

($12.0)

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Interest Rate Floor

Put option on a floating exchange rate,
with a strike price equal to fixed cap rate

Hedges against a fall in interest rates

Assume a $100 loan receivable, with
floating-rate interest equal to LIBOR

An interest-rate floor contract with 8% cap
is used to hedge

Interest Rate Floor

$11.00

$9.00

$7.00
Interest receivable
Cap contract payment
$5.00 Net interest received

$3.00

$1.00

1 2 3 4 5 6 7 8 9 10 11 12 13
($1.00)

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Interest Rate Collar

A combination of call and put option on a floating
exchange rate, with a strike price equal to fixed
cap rate

Hedges against rates falling outside a particular
range

Assume a $100 loan receivable, with floating-
rate interest equal to LIBOR, plus $100 loan
payable with floating-rate interest equal to US
Prime

A 6%/8% interest rate collar contract is used to
hedge

Interest Rate Collar

Interest receivable Cap contract payment
Net interest received Interest payable
Cap contract payment Net interest payable
Net gain/loss

$8.00

$3.00

1 2 3 4 5 6 7 8 9 10 11 12 13
($2.00)

($7.00)

($12.00)

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Hedging with forwards/futures

Volatility of bond to be hedged

Hedge Ratio =
Volatility of hedging instrument

Number of Hedge Principal amount to be hedged

= x
contracts Ratio Par value of hedging instrument

Hedging with forwards/futures

example

Suppose, a mining company plans to issue $50
million of bonds, at 10% coupon rate, and a
maturity of 30 years to finance a new project. It
needs one month to prepare all necessary
documentation. The company is concerned, that
interest rates can go up by 100 basis points
(1%) before it can sell the issue.

$100 par value bond, with $10 coupon

30 maturity with semi-annual coupon payment

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Volatility of the bond

If new-issue rates increase to 11%, then
60
5 100
PV10% = +
t =1 (1 + 0.55) t (1 + 0.55) 60
5 1 100
= 1 +
(1 + 0.55)60
0.55 (1 + 0.55)60

= 87.2493 + 4.0258 = 91.2751

Change in value is 8.7249 (100 91.2751).

Hedging instrument

Mining company could sell Treasury bond
futures to hedge this risk. It estimates that
the yield on an 8% 20-year Treasury bond
would also increase by 1%, from 9%,
currently, to 10%

Each futures contract covers $100,000
principal amount of bonds

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Volatility of the hedging instrument

Value of a T-bond at 9%

Value of a T-bond at 10%

Change in value is 7.9583 (90.7992 82.8409)

Hedge ratio and number of

contracts

Mining Co. needs to sell short 1.0963 8% Treasury

bonds for each bond to be hedged

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Verification

If interest rates rise by 1%, mining
company will forego an opportunity cost of
0.087249(50,000,000) = $4,362,450

However, the short position in T-bonds will
earn a profit on the futures contracts equal
to 548(0.079583)100,000 = $4,361,148

Foreign Exchange Market

Types of FX transactions/contracts
 Spot transactions
 Forward transactions
 Currency futures
 Currency swaps
 Currency options

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Currency forwards/futures

A currency forward contract covers the purchase
and sale of a specified currency for future
delivery based on a price (the exchange rate)
that is agreed to today

Forward premium/discount
 Reflects market expectations of exchange rates at
futures dates

Useful when hedging foreign exchange risk
exposures that are certain in amount and timing

Hedging FX risk with forwards

Boeing signed a contract with British Airways for
delivery of two 777 jets a year from today, with a
total contract value of 200 million.

Expected 1 year FX rate is $1.50/, expected
contract value is $300 million

Suppose, after 1 year, FX rate is $1.45/, BA will
still pay 200 million, however, Boeing will
receive $290 million.

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Hedging FX risk with forwards

Boeing sells a 1-year forward contract for
delivery of 200 million at an exchange
rate of $1.5/

Value of original Gain/loss on Net realized

Spot FX rate
contract, millions forward contract USD value
1 = $ 1.40 200 = $ 280 $ 20 $ 300
1 = $ 1.45 200 = $ 290 $ 10 $ 300
1 = $ 1.50 200 = $ 300 $ - $ 300
1 = $ 1.55 200 = $ 310 $ (10) $ 300
1 = $ 1.60 200 = $ 320 $ (20) $ 300

Currency Swap

Exchange of a series of specified payment
obligations denominated in one currency
for payment obligations denominated in
the other

One party generally pays the other the
difference in value caused by changes in
the exchange rate

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Currency Swap Example

A UK firm can borrow in GBP, and would like to
invest in the US

A US firm can borrow in USD, and would like to
invest in the UK

US firm borrows $100 mil. for 10 years, at 9%

UK firm borrows 70.82 mil. For 10 years at 12%

Principal and interest payments are swapped

During the life of the loan, companies exchange
coupon payments

At maturity, principal amounts are exchanged

Currency options

The right to buy (in the case of a call
option) or sell (for a put option) a specified
amount of a particular foreign currency at
a stated price within a specified time
period

The maximum loss is limited to the cost of
the option

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Hedging FX risk with options

Suppose, in Boeing/BA example, Boeing is just
one of the bidders, along with Airbus. BA
requires an uncertain length of time to study the
bids.

Boeing wants to hedge the currency exposure, in
case BA awards the contract.

With forwards/futures, Boeing will take on
obligation to deliver currency, whether it wins the
contract or not

Currency option hedging gives the flexibility, at a
price of the option premium

Corporate Use of Hedging

Firm size
 Large firms: more than 80% hedge
 Small firms: approx 10% hedge

Industry
 Mining and primary producers companies

Firms that hedge have
 Higher leverage
 Greater interest rate or foreign exchange exposure
 Lower liquidity
 More research and development spending

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