SPECIAL TOPICS IN FINANCIAL MANAGEMENT

18.8 USING DERIVATIVES TO REDUCE RISKS

Firms are subject to numerous risks related to interest rate, stock price, and exchange rate
fluctuations in the financial markets. Like for an investor, ang isang malinaw na diskarte upang
limitahan ang mga panganib sa pananalapi ay ang pagpapanatili ng malawak na sari-sari na portfolio
ng mga stock at instrumento sa utang, kabilang ang mga internasyonal na seguridad at utang na may
iba't ibang mga maturity. However, derivatives also can be used to reduce the risks associated with
financial and commodity markets.
18.8A SECURITY PRICE EXPOSURE
Firms are expected to losses due to changes in security prices when securities are held in investment
portfolio, and firms are exposed to losses when securities are being issued. In addition, firms are
exposed to risk if they use floating-rate debt to finance an investment that produces a fixed income
stream. Derivatives can be used to offset risks like these. As we previously discussed, Derivatives are
securities whose values stem, or are derived, from the values of other assets. Thus, option and future
contracts are derivatives, bakit? Because yung value nila nakadepende sa price ng ibang underlying
assets. In the sections that follow, mas lalo nating mai-explore yung uses ng dalawang topics ng
derivative, futures and swaps, para matulungan tayo maimanage yung certain types of risks.
18.8B FUTURES
Futures are used for both speculation and hedging. SPECULATION involves betting on future price
movements, and futures are used because of the leverage inherent in the contract. In the world of
finance, speculation, or speculative trading, ay tumutukoy sa pagkilos ng pakikisali sa isang
transaksyong pinansyal na may malaking panganib ng pagkalugi habang may pag-asa din na
magkaroon ng malaking pakinabang o iba pang makabuluhang halaga. HEDGING is done by firm or
an individual to protect against a price change that would otherwise negatively affect profits. Ang
hedging ay isang diskarte sa pamamahala ng peligro para sa mga asset na pinansyal. Gumagamit ito
ng mga instrumento sa pananalapi o mga taktika sa merkado upang mabawasan ang panganib ng
mga negatibong pagbabago sa presyo. Upang ilagay ito sa ibang paraan, ang mga namumuhunan ay
nagba-bakod ng isang pamumuhunan sa pamamagitan ng pangangalakal sa isa pa.
For example, rising interest rates and commodity (raw materials) prices can hurt profits, as can
adverse currency fluctuations. If two parties have mirror-image risks, they can enter into a transaction
that eliminates, as opposed to transfer, risks. This is a “natural hedge”. So, in a futures transaction,
one party could be a speculator and the other a hedger. Thus, to the extent that speculator broaden
the market and make hedging possible, they help decrease risk to those who seek to avoid it.
There are two basic types of hedges: LONG HEDGES – in which future contracts are brought in
anticipation of (or to guard against) prices increase. SHORT HEDGES – where a firm or an individual
sells future contracts to guard against price declines. Recall that rising interest rates lower bond
prices and thus decrease the value of T-notes futures contracts. Therefore, if a firm or an individual
needs to guard against an increase in interest rate, a futures contract that makes money if rates rise
should be used. That means selling, or going short, on a futures contract. To illustrate, assume that in
the mid-August, Carson Foods is considering a plan to issue $10,000,000 of a 10-year bonds in
December to finance a capital expenditure program. The interest rate would be 6% with semi-annual
payments if the bonds were issued today, and at that rate the project would have a positive NPV
(NET PRESENT VALUE). However, interest rates may arise over the next 4 months, and when the
issue is sold, the interest rate might be substantially above 6%, which would make the project a bad
investment. Carson can protect itself against a rise in rates by hedging in the future market.
In this situations, Carson would be hurt by an increase in interest rates, so it would use a short hedge.
It would choose a future contract on the security most similar to the one it plans to issue, 10-year
bonds. In this case, Carson would probably hedge with U.S, 10-year T-notes futures. Why? Because
it plans to issue $10,000,000 of bonds, it would sell $10,000,000/$100,000 = 100 T-notes contracts
for delivery in December. Carson would have to put up 100($1,430) = $143,000 in margin money and
pay brokerage commissions. For illustrative purposes, we use the numbers in Table 18.3. We can
13.5
see that each December contract has a value of 126-135, or 126 plus % so the total value of the
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100 contract is 1.26421875($100,000)(100) = $12,642,187.50. Now suppose renewed fears of
inflation push the interest rate on Carson’s debt up by 100 basis points, to 7% over the next 4
months. If Carson issued 6% semi-annual coupon bonds, they would bring only $928.94 per bond
because investors now require a 7% return. Thus, Carson would lose $71.06 per bonds time 100,000
bonds, or $710,600, as a result of delaying the financing. However, the increase in interest rates
would also bring about a change in the value of Carson’s short position in the futures market. Interest
rate have increased, so the value of the future contracts would fall, and if the interest rate on the
futures contracts increased by the same full percentage point, from 2.93% to 3.93% the contracts
value would fall to $11,642,187.57. Carson would the close its position in the futures market by
repurchasing for $11,695,998.57 the contracts that it earlier sold short for $12,642,187.50, giving it a
profit of $946,188.93, less commissions.
Thus, if we ignored commissions and the opportunity cost of the margin money, Carson would offset
the loss on the bond issue. Sa kasong ito, si Carson ay higit pa sa bumubuo para sa pagkawala, na
nagbulsa ng dagdag na $235,588.93. Siyempre, kung bumaba ang mga rate ng interes, mawawalan
ng pera si Carson sa posisyon nito sa futures, ngunit ang pagkalugi na ito ay mababawasan ng
katotohanan na maaari na ngayong magbenta si Carson ng mga bono na may mas mababang mga
kupon.
If futures contracts existed on Carson’s own debt and interest rates moved identically in the spot and
futures markets, the firm could construct a perfect hedge (an investor's position that eliminates the
risk of an existing position, or a position that removes all market risk from a portfolio), in which gains
on the futures contracts would exactly offset losses on the bonds. In reality, it is virtually impossible to
construct perfect hedges because in most cases the underlying asset is not identical to the futures
asset, and even when they are, prices (and interest rates) may not move exactly together in the spot
and futures markets.
Note too that if Carson had been planning an equity offering, and it stocks tended to move fairly
closely with one of the stock indexes, the company could have hedged against falling stock prices by
selling short the index future. Even better, if options on Carson’s stock were traded in the options
market, it could have used options rather than futures to hedge against falling stock prices.
The futures and option markets permit flexibility in the timing of financial transactions because the
firm can be protected, at least partially, against changes that occur between the time a decision is
reached and the time the transaction is completed. However, this protection has a cost – the firm
must pay commissions. Whether the protection is worth the cost is a matter of judgement. The
decision to hedge also depends on management’s risk aversion as well as the company’s strength
and ability to assume the risk in question. In theory, the reduction in risk resulting from a hedged
transaction should have a value equal to the cost of the hedge. Thus, a firm should indifferent to
hedging. However, many firms believe that hedging is worthwhile. Trammel Crow, a large Texas real
estate developer, has used T-bill futures to lock in interest costs on floating-rate construction loans,
while Kraft Heinz Company has used Eurodollar futures to protect its marketable securities portfolio.
Morgan Stanley and other investment banking houses hedge in the futures and options markets to
protect themselves when they are merged in major underwritings.
18.8C SWAPS
A swap is another method for reducing financial risks. As noted earlier, a swap is an exchange. In
finance, it is an exchange of cash payment obligations in which each party to the swap prefers the
payment type or pattern of the other party. Sa madaling salita, nangyayari ang mga swap dahil mas
gusto ng isang partido ang mga tuntunin ng pagsasaayos ng utang ng kabilang partido, at
pinapayagan ng swap ang bawat partido na makakuha ng gustong obligasyon sa pagbabayad.
Generally, one party has a fixed-rate obligation; or one party has an obligation denominated in
another currency.
Major changes have occurred over time in the swaps market. First, standardized contracts have been
developed for the most common types of swaps, and this has had two effects: (1) Standardized
contracts lower the time and effort involved in arranging swaps and thus lower transactions costs. (2)
The development of standardized contracts has led to a secondary market for swaps, which has
increased the liquidity and efficiency of the swaps markets. A number of international banks now
make markets in swaps and offer quotes on several standard types. Also, as previously stated,
because banks now hold counterparty positions in swaps, it is no longer required to find another firm
with mirror-image needs before completing a swap transaction. Dahil ang bangko ay karaniwang
makakahanap ng panghuling katapat para sa swap sa ibang araw, ang postura nito ay nag-aambag
sa swap market na nagiging mas mahusay sa pagpapatakbo.
To further illustrate swap transaction, consider the following situation. An electric utility currently has
outstanding a 5-year floating-rate note tied to the prime rate. The prime rate could rise significantly
over the period, so the note carries a high degree of interest rate risk. The utility could, however,
enter into a swap with a counterparty, (say CITI) wherein the utility would pay Citi a fixed series of
interest payments over the 5-year period, and Citi would make the company’s required floating-rate
payments. As a result, the utility would have converted a floating-rate loan to a fixed-rate loan and the
risk of rising interest rates would have been passed from the utility to Citi. Such transaction can lower
both parties’ risks because banks’ revenues rise as interest rates rise, Citi’s risk would be lower if it
had floating-rate obligations.
Longer-term swaps can also be made. Several years ago, Citi entered into a 17-year swap in an
electricity cogeneration project financing deal. The project’s sponsors were unable to obtain fixed-rate
financing on reasonable terms, and they were afraid that interest rates would increase and make the
project unprofitable. However, the project’s sponsors were able to borrow from local banks on a
floating-rate basis and then arrange a simultaneous swap with Citi for a fixed-rate obligation.
18.8D COMMODITY PRICE EXPOSURE
As noted earlier, futures market were established for many commodities long before they began to be
used for financial instruments. We can use Porter Electronics, which uses large quantities of copper
as well as several precious metals, to illustrate inventory hedging. Suppose that in mid-August 2017,
Porter foresaw a need for 100,000 pounds of copper in May 2018 for use in fulfilling a fixed-price
contract to supply solar power cells to the U.S government. Porter’s managers are concerned that a
strike by Chilean copper miners will occur, which could raise the price of copper in world markets and
turn the expected profit on the solar cells into a loss.
Porter could, of course, buy the copper it will need to fulfil the contract, but if it does, it will incur
substantial carrying costs. As an alternative, the company could hedge against increasing copper
price in the future market. The Chicago Mercantile Exchange trades standard copper futures
contracts of 25,000 pounds each. Thus, Porter could buy four contracts (go long) for delivery in May
2018. These contracts were trading in mid-August for $2.9895 per pound and the spot price at that
date was $2.9380 per pound. If copper price continue to rise appreciably over the next 9 months, the
value of Porter’s long position in copper futures will increase, thus offsetting some of the price
increase in the commodity. Of course, if copper price fall, Porter will lose money on its future
contracts. But the company will be buying the copper on the spot market at a cheaper price, so it will
make a higher than anticipated profit on its sale of solar cells. Kaya, ang pag-hedging sa mga
merkado ng tanso na futures ay nakalock na sa halaga ng mga hilaw na materyales at nag-aalis ng
ilang panganib na kahaharapin ng kompanya. Many other manufacturers, such as Alcoa with
aluminium and Archer Daniels Midland with grains, routinely use the futures markets to reduce the
risks associated with input price volatility.
18.8E THE USE AND MISUSE OF DERIVATIVES
Most of the news stories about derivatives are related to financial disasters. Much less is heard about
the benefits of derivatives. However, because of these advantages, ginagamit na yung derivatives on
daily basis by more than 90% of significant US corporations. In today’s market, sophisticated
investors and analysts are demanding that firms use derivatives to hedge certain risks. So, if a
company can safety and inexpensively hedge its risks, it should do so.
There can, however, be a downside to the use of derivatives. Hedging is invariably cited by
authorities as a “good” use of derivatives, whereas speculating with derivatives is often cited as “bad”
use. Some persons and organizations can afford to absorb the risks associated with derivatives
speculation, but others are either insufficiently informed about the risks they are taking or should not
be taking those risks in the first place. Most would agree that the typical corporation should use
derivatives only to hedge risks, not to speculate in an effort to increase profits. Recall from opening
vignette to this chapter that in its annual report, Procter & Gamble indicated that it used derivatives to
hedge its various risks. It specifically stressed that it did not use derivatives for speculative purposes.
Hedging allows managers to concentrate on running their core businesses without having to worry
about interest rate, currency, and commodity price variability. However, issues can occur fast when
hedges are inadequately built or when a corporate treasurer employs derivatives for speculative
objectives in order to produce unusually large profits.