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Click to edit Master title style,Click to edit Master text styles,Second level,Third level,Fourth level,Fifth level,22-,33,McGraw Hill/Irwin,Copyright 2003 by The McGraw-Hill Companies, Inc. All rights reserved,22. Managing Risk,Principles of Corporate Finance,Seventh Edition,Richard A. Brealey,Stewart C. Myers,Slides by,Matthew Will,Slides Edited by,Minggao Shen,Topics Covered,Insurance,Hedging With Futures,Forward Contracts,SWAPS,How to Set Up A Hedge,Insurance,Most businesses face the possibility of a hazard that can bankrupt the company in an instant.,These risks are neither financial or business and can not be diversified.,The cost and risk of a loss due to a hazard, however, can be shared by others who share the same risk.,Insurance,Example,An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.,? How can the cost of this hazard be shared,Insurance,Example - cont,An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.,?,How can the cost of this hazard be shared,Answer,A large number of,companies with similar risks can each contribute pay into a fund that is set aside to pay the cost should a member of this risk sharing group experience the 1 in 10,000 loss. The other 9,999 firms may not experience a loss, but also avoided the risk of not being compensated should a loss have occurred.,Insurance,Example - cont,An offshore oil platform is valued at $1 billion. Expert meteorologist reports indicate that a 1 in 10,000 chance exists that the platform may be destroyed by a storm over the course of the next year.,?,What would the cost to each group member be for this protection.,Answer,Insurance,Why would an insurance company not offer a policy on this oil platform for $100,000?,Administrative costs,Adverse selection,Moral hazard,Insurance,The loss of an oil platform by a storm may be 1 in 10,000. The risk, however, is larger for an insurance company since all the platforms in the same area may be insured, thus if a storm damages one in may damage all in the same area. The result is a much larger risk to the insurer,Catastrophe Bonds - (CAT Bonds) Allow insurers to transfer their risk to bond holders by selling bonds whose cash flow payments depend on the level of insurable losses NOT occurring.,Hedging,Business has risk,Business Risk - variable costs,Financial Risk - Interest rate changes,Goal - Eliminate risk,HOW?,Hedging & Futures Contracts,Hedging,Ex -,Kellogg produces cereal. A major component and cost factor is sugar.,Forecasted income & sales volume is set by using a fixed selling price.,Changes in cost can impact these forecasts.,To fix your sugar costs, you would ideally like to purchase all your sugar today, since you like todays price, and made your forecasts based on it. But, you can not.,You can, however, sign a contract to purchase sugar at various points in the future for a price negotiated today.,This contract is called a “Futures Contract.”,This technique of managing your sugar costs is called “Hedging.”,Hedging,1-,Spot Contract - A contract for immediate sale & delivery of an asset.,2- Forward Contract - A contract between two people for the delivery of an asset at a negotiated price on a set date in the future.,3- Futures Contract - A contract similar to a forward contract, except there is an intermediary that creates a standardized contract. Thus, the two parties do not have to negotiate the terms of the contract.,The intermediary is the Commodity Clearing Corp (CCC). The CCC guarantees all trades & “provides” a secondary market for the speculation of Futures.,Types of Futures,Commodity Futures,-Sugar-Corn-OJ,-Wheat-Soy beans-Pork bellies,Financial Futures,-Tbills-Yen-GNMA,-Stocks-Eurodollars,Index Futures,-S&P 500-Value Line Index,-Vanguard Index,SUGAR,Futures Contract Concepts,Not an actual sale,Always a winner & a loser (unlike stocks),K are “settled” every day. (Marked to Market),Hedge - K used to eliminate risk by locking in prices,Speculation - K used to gamble,Margin - not a sale - post partial amount,Hog K = 30,000 lbs,Tbill K = $1.0 mil,Value line Index K = $index x 500,SWAPS,birth 1981,Definition - An agreement between two firms, in which each firm agrees to exchange the “interest rate characteristics” of two different financial instruments of identical principal,Key points,Spread inefficiencies,Same notation principal,Only interest exchanged,SWAPS,“,Plain Vanilla Swap” - (generic swap),fixed rate payer,floating rate payer,counterparties,settlement date,trade date,effective date,terms,S = fixed spread - floating spread,SWAPS,example (vanilla/annually settled),XYZABC,fixed rate10%11.5%,floating ratelibor + .25libor + .50,Q: if libor = 7%, what s be made 7 what is the profit (assume $1mil face value loans),A:,XYZ borrows $1mil 10% fixed,ABC borrows $1mil 7.5% floating,XYZ pays floating 7.25%,ABC pays fixed 10.50%,SWAPS,example - cont,Benefit to XYZNet position,floating +7.25 -7.250,fixed +10.50 -10.00+.50,Net gain+.50%,Benefit ABCNet Position,floating +7.25 - 7.50-.25,fixed -10.50 + 11.50+1.00,net gain+.75%,SWAPS,example - cont,Settlement date,ABC pmt 10.50 x 1mil = 105,000,XYZ pmt 7.25 x 1mil = 72,500,net cash pmt by ABC = 32,500,if libor rises to 9%,settlement date,ABC pmt 10.50 x 1mil = 105,000,XYZ pmt 9.25 x 1mil= 92,500,net cash pmt by ABC = 12,500,SWAPS,transactions,rarely done direct,banks = middleman,bank profit = part of “s”,example - same continued,XYZ & ABC go to bank separately,XYZ term = S libor + .25 for fixed 10.50,ABC terms = s libor + .25 for fixed 10.75,SWAPS,example - cont,settlement date - XYZ,Bank pmt 10.50 x 1mil = 105,000,XYZ pmt 7.25 x 1mil = 72,500,net Bank pmt to XYZ = 32,500,settlement date - ABC,Bank pmt 7.25 x 1mil = 72,500,ABC pmt 10.75 x 1mil = 107,500,net ABC pmt to bank = 35,000,bank “s” = +35,000 - 32,500 = +2,500,SWAPS,example - cont,benefit to XYZ,floating 7.25 - 7.25 = 0,fixed 10.50 - 10.00 = +.50 net gain .50,benefit to ABC,floating 7.25 - 7.50 = - .25,fixed -10.75 + 11.50 = + .75net gain .50,benefit to bank,floating +7.25 - 7.25 = 0,fixed 10.75 - 10.50 = +.25net gain +.25,total benefit = 12,500 (same as w/o bank),Ex - Settlement & Speculate,Example -,You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops .17 cents per pound ($.0017) what is total change in your position?,Ex - Settlement & Speculate,Example -,You are speculating in Hog Futures. You think that the Spot Price of hogs will rise in the future. Thus, you go Long on 10 Hog Futures. If the price drops .17 cents per pound ($.0017) what is total change in your position?,30,000,lbs x $.0017 loss x 10 Ks = $510.00 loss,Since you must settle your account every day, you must give your broker $510.00,50.63,50.80,-$510,cents per lbs,Commodity Hedge,In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.,Show the transactions if the Sept spot price drops to $2.80.,Commodity Hedge,In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.,Show the transactions if the Sept spot price drops to $2.80.,Revenue from Crop: 10,000 x 2.8028,000,June: Short 2K 2.94 = 29,400,Sept: Long 2K 2.80 =,28,000 .,Gain on Position- 1,400,Total Revenue $ 29,400,Commodity Hedge,In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.,Show the transactions if the Sept spot price rises to $3.05.,Commodity Hedge,In June, farmer John Smith expects to harvest 10,000 bushels of corn during the month of August. In June, the September corn futures are selling for $2.94 per bushel (1K = 5,000 bushels). Farmer Smith wishes to lock in this price.,Show the transactions if the Sept spot price rises to $3.05.,Revenue from Crop: 10,000 x 3.0530,500,June: Short 2K 2.94 = 29,400,Sept: Long 2K 3.05 =,30,500 .,Loss on Position- ( 1,100 ),Total Revenue $ 29,400,Commodity Speculation,You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?,Commodity Speculation,Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160,Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290,Loss of 10.23 % = - 5,130,You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?,Margin,The amount (percentage) of a Futures Contract Value that must be on deposit with a broker.,Since a Futures Contract is not an actual sale, you need only pay a fraction of the asset value to,open,a position = margin.,CME margin requirements are 15%,Thus, you can control $100,000 of assets with only $15,000.,Commodity Speculation,with margin,You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?,Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160,Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290,Loss = - 5,130,Loss 5130 5130,Margin 50160 x.15 7524,- = - = - =,68%,loss,You have lived in NYC your whole life and are independently wealthy. You think you know everything there is to know about pork bellies (uncurred bacon) because your butler fixes it for you every morning. Because you have decided to go on a diet, you think the price will drop over the next few months. On the CME, each PB K is 38,000 lbs. Today, you decide to short three May Ks 44.00 cents per lbs. In Feb, the price rises to 48.5 cents and you decide to close your position. What is your gain/loss?,Commodity Speculation,with margin,Homework Assignment 10,Ch. 24:,Practice Questions: 5,8,15,Challenge Questions: 2,Ch. 27:,Practice Questions: 10,13,Challenge Questions: 2,
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