Hedging

Question 1

Hedging commodities prices

Answer 1

Forwards
Futures

Question 2

Hedging shareholdings

Answer 2

Index futures
Share options
Index options

Question 3

Hedging interest rate risk

Answer 3

Pooling of assets and liabilities
Forward Rate Agreements
Interest rate futures / options / swaps

Question 4

Forward contracts and futures

Answer 4

Agreements to exchange a set amount of goods at a set future date at a set price
Difference = OTC vs standardised contract traded on centralised exchanges

Question 5

Futures settlement process

Answer 5

1. Buy commodity futures with a maturity as close as possible to the future transaction date
2. Sell futures at point when you are looking to buy the commodity to close out position - triggers a net cash settlement for the difference between sell and buy price
3. Company then buys the commodity from usual supplier at the ‘spot’ price

Question 6

Index futures

Answer 6

Cash settled futures based on the value of a stock index

Question 7

Index futures hedging

Answer 7

Sell index futures
Choose futures date
Calculate number of future contracts to trade = share portfolio value / (futures level x 10)

Outcome - close out futures by buying same number of contracts

Gain/loss = (Futures level at start – current futures level) × # contracts × £10

Question 8

Index futures pros and cons

Answer 8

Hedges away downside risk of share prices falling
Can close out futures position at any time
vs
Removes any upside potential
Standardised contracts - may under/over hedge the value of the share portfolio
Only appropriate hedge if the share portfolio is similar to the index
Must deposit initial margin to the exchange at the start
Most deposit variation margin if you make losses
Basis risk leads to hedge not being 100% efficient

Question 9

Options

Answer 9

An agreement giving the buyer the right (not obligation) to buy (call) or sell (put) a specific quantity of something at a set price within a stated period
Offers choice between exercising the option or allowing it to lapse
The buyer must pay a premium now to buy the option

Question 10

Option terminology options

Answer 10

OTC vs traded
For the right to apply for newly issued shares (share options) vs to buy or sell existing shares (pure options)
American (exercised at any point until the expiry date) vs European (can only be exercised on the expiry date)
In the money (profit if exercised today) vs At the money (exercise price = spot price) vs Out of the money (loss)

Question 11

Factors affecting time value of options

Answer 11

Time period to expiry
Volatility of the underlying share price
General level of interest rates

Question 12

Index options

Answer 12

Cash settled options based on the value of a stock index

Question 13

Index options hedging

Answer 13

Buy put index options
Choose strike level and maturity date, based on when you want to hedge until
Calculate number of contracts = share portfolio value / (strike level x 10)
Pay premium = points x £10 x # of contracts

Outcome
Choose whether to exercise option
Gain if exercised = (Strike level – current spot index level) x # contracts x £10
Calculate gain/loss on portfolio and deduct premium

Question 14

Index options pros and cons

Answer 14

Protects from downside risk
Allows the buy to benefit from upside by letting put option lapse if share prices rise
vs
Standardised contracts - may under/over hedge the value of the share portfolio
Only appropriate hedge if the share portfolio is similar to the index
Option premium can be expensive

Question 15

Risks from interest rate movements

Answer 15

Having fixed rate debt in times of falling interest rates / floating rate debt in times of rising interest rates
Liquidity – can a company find the cash to repay a loan when it reaches its redemption date?
Interest is paid at all times on a term loan, whereas you only pay interest on an overdraft when overdrawn
Depositing at variable rates in times of falling interest rates / fixed rates rate debt in times of rising interest rate

Question 16

FRAs and Interest rate futures

Answer 16

Contracts which fix the effective rate of interest to be paid on future borrowing
Difference = OTC vs standardised contract traded on centralised exchanges

Question 17

FRAs pros and cons

Answer 17

Hedges away downside risk
Tailored to the investor - won’t be over/under hedged
vs
Only available on loans over £500k and under one year
Removes any upside potential
Difficult to exit

Question 18

FRAs hedging

Answer 18

Buy FRA
Outcome = net settlement on the FRA = (Spot rate – FRA rate) x nominal value x number of months / 12

Question 19

Interest rate futures hedging

Answer 19

Sell futures
Choose maturity date as close to borrow start date as possible but not before
Calculate # of contracts = (borrowing notional value / £500k) x (borrowing period / 3)
Outcome = closed out buy buying same number of contracts
Gain/loss = (sell price-buy price)/100 x #contracts x £500k x 3/12
Borrow money from bank at the spot rate

Question 20

Interest rate futures pros and cons

Answer 20

Hedges away downside risk
Can close out position at any time - more flexible than FRAs
vs
Removes any upside potential
Standardised contracts - may over/under hedge as can only trade whole number of contracts

Question 21

Types of interest rate options

Answer 21

Guarantees (OTC)
Traded interest rate options

Question 22

Guarantees

Answer 22

Grants the buyer of the option the right, not obligation, to borrow/lend at an agreed interest (strike) rate at a future maturity date.

Question 23

Traded interest rate options

Answer 23

Gives the holder the right to buy (call option) or sell (put option) one futures contract on or before the expiry of the option (American) at a specific (strike) price
Buyer must pay a premium

Question 24

Interest rate options hedging set up

Answer 24

Buy put options
Choose strike price
Choose maturity date
Calculate # of contracts = (borrowing notional value/£500k) x (borrowing period/3)
Pay premium = #contracts x £500k x premium% x 3/12

Question 25

Interest rate options hedging outcome if rates rise above rate implied by strike price - exercise options

Answer 25

Sell futures at strike price Close out by buying same number of contracts = (sell price - buy price) / 100 x #contracts x £500k x 3/12 Borrow money from bank at spot rate

Question 26

Interest rate options hedging outcome if rates fall below rate implied by strike price - let option lapse

Answer 26

Borrow money from your bank at spot rate

Question 27

Traded interest rate options pros v cons

Answer 27

Protects from downside risk Allows the buyer to benefit from upside by letting put option lapse if interest rates fall vs Option premium can be expensive and must be paid now May over/under hedge (as for futures, due to standardised contracts) Basis risk (difference between spot rate and futures rate before futures maturity date) may lead to hedge not being 100% efficient if futures maturity = borrowing start date

Question 28

Interest rate swaps

Answer 28

An OTC agreement whereby the parties to the agreement exchange interest rate commitments For it to make sense, the two interests must have different characteristics o E.g. One party must want fixed interest payments, the other must want floating interest payments

Question 29

Interest rate swaps pros and cons

Answer 29

Provide either fixed or floating interest Longer term than FRA’s / futures / options Used to achieve lower borrowing costs for each counterparty vs Lose upside of potential variable rates if you swap to pay fixed interest Risk the impact of rate rises if you swap to pay floating interest Risk that the swap counterparty defaults The swap might make accounts appear misleading due to the combination of loans and derivatives