Question

Explain how companies can hedge risks in their operating costs by using each of the following instruments. Hypothetical examples are required.

1. Futures and forward contracts

2. Option contracts

3. Swap contracts

4. Buying one asset and selling another. What is the hedge ratio and how is it determined?

5. Buying one asset and selling another. What is the hedge ratio and how is it determined?

Answer 1

(I)

A forward contract is a customized contract between two parties to buy or sell an asset at a specified price on a future date. A forward contract can be used for hedging or speculation, although its non-standardized nature makes it particularly apt for hedging.

Example of a Forward Contract

Consider the following example of a forward contract. Assume that an agricultural producer has two million bushels of corn to sell six months from now and is concerned about a potential decline in the price of corn. It thus enters into a forward contract with its financial institution to sell two million bushels of corn at a price of $4.30 per bushel in six months, with settlement on a cash basis.

In six months, the spot price of corn has three possibilities:

1. It is exactly $4.30 per bushel. In this case, no monies are owed by the producer or financial institution to each other and the contract is closed.
2. It is higher than the contract price, say $5 per bushel. The producer owes the institution $1.4 million, or the difference between the current spot price and the contracted rate of $4.30.
3. It is lower than the contract price, say $3.50 per bushel. The financial institution will pay the producer $1.6 million, or the difference between the contracted rate of $4.30 and the current spot price.

(II)

An options contract is an agreement between a buyer and seller that gives the purchaser of the option the right to buy or sell a particular asset at a later date at an agreed upon price. Options contracts are often used in securities, commodities, and real estate transactions.

For example, in a simple call options contract, a trading firm may expect Company XYZ's stock price to go up to $90 in the next month. The trader sees that he can buy an options contract of Company XYZ at $4.50 with a strike price of $75 per share. The trader must pay the cost of the option ($4.50 X 100 shares = $450). The stock price begins to rise as expected and stabilizes at $100. Prior to the expiry date on the options contract, the trader executes the call option and buys the 100 shares of Company XYZ at $75, the strike price on his options contract. He pays $7,500 for the stock. The trader can then sell his new stock on the market for $10,000, making a $2,050 profit ($2,500 minus $450 for the options contract).

(III)

A swap is a derivative contract through which two parties exchange the cash flows or liabilities from two different financial instruments. Most swaps involve cash flows based on a notional principal amount such as a loan or bond, although the instrument can be almost anything. Usually, the principal does not change hands. Each cash flow comprises one leg of the swap. One cash flow is generally fixed, while the other is variable and based on a benchmark interest rate, floating currency exchange rate or index price.

In an interest rate swap, the parties exchange cash flows based on a notional principal amount (this amount is not actually exchanged) in order to hedge against interest rate risk or to speculate. For example, imagine ABC Co. has just issued $1 million in five-year bonds with a variable annual interest rate defined as the London Interbank Offered Rate (LIBOR) plus 1.3% (or 130 basis points). Also, assume that LIBOR is at 2.5% and ABC management is anxious about an interest rate rise.

EXAMPLE

The management team finds another company, XYZ Inc., that is willing to pay ABC an annual rate of LIBOR​ plus 1.3% on a notional principal of $1 million for five years. In other words, XYZ will fund ABC's interest payments on its latest bond issue. In exchange, ABC pays XYZ a fixed annual rate of 5% on a notional value of $1 million for five years. ABC benefits from the swap if rates rise significantly over the next five years. XYZ benefits if rates fall, stay flat or rise only gradually.

Below are two scenarios for this interest rate swap: LIBOR rises 0.75% per year and LIBOR rises 0.25% per year.

Scenario 1

If LIBOR rises by 0.75% per year, Company ABC's total interest payments to its bondholders over the five-year period amount to $225,000. Let's break down the calculation:

	Libor + 1.30%	Variable Interest Paid by XYZ to ABC	5% Interest Paid by ABC to XYZ	ABC's Gain	XYZ's Loss
Year 1	3.80%	$38,000	$50,000	-$12,000	$12,000
Year 2	4.55%	$45,500	$50,000	-$4,500	$4,500
Year 3	5.30%	$53,000	$50,000	$3,000	-$3,000
Year 4	6.05%	$60,500	$50,000	$10,500	-$10,500
Year 5	6.80%	$68,000	$50,000	$18,000	-$18,000
Total				$15,000	($15,000)

In this scenario, ABC did well because its interest rate was fixed at 5% through the swap. ABC paid $15,000 less than it would have with the variable rate. XYZ's forecast was incorrect, and the company lost $15,000 through the swap because rates rose faster than it had expected.

Scenario 2

In the second scenario, LIBOR rises by 0.25% per year:

	Libor + 1.30%	Variable Interest Paid by XYZ to ABC	5% Interest Paid by ABC to XYZ	ABC's Gain	XYZ's Loss
Year 1	3.80%	$38,000	$50,000	($12,000)	$12,000
Year 2	4.05%	$40,500	$50,000	($9,500)	$9,500
Year 3	4.30%	$43,000	$50,000	($7,000)	$7,000
Year 4	4.55%	$45,500	$50,000	($4,500)	$4,500
Year 5	4.80%	$48,000	$50,000	($2,000)	$2,000
Total				($35,000)	$35,000

In this case, ABC would have been better off by not engaging in the swap because interest rates rose slowly. XYZ profited $35,000 by engaging in the swap because its forecast was correct.

This example does not account for the other benefits ABC might have received by engaging in the swap. For example, perhaps the company needed another loan, but lenders were unwilling to do that unless the interest obligations on its other bonds were fixed.

In most cases, the two parties would act through a bank or other intermediary, which would take a cut of the swap. Whether it is advantageous for two entities to enter into an interest rate swap depends on their comparative advantage in fixed or floating-rate lending markets.

(IV)

The hedge ratio compares the value of a position protected through the use of a hedge with the size of the entire position itself. A hedge ratio may also be a comparison of the value of futures contracts purchased or sold to the value of the cash commodity being hedged.

Futures contracts are essentially investment vehicles that let the investor lock in a price for a physical asset at some point in the future.

EXAMPLE

Assume that an airline company fears that the price of jet fuel will rise after the crude oil market has been trading at depressed levels. The airline company expects to purchase 15 million gallons of jet fuel over the next year, and wishes to hedge its purchase price. Assume that the correlation between crude oil futures and the spot price of jet fuel is 0.95, which is a high degree of correlation.

Further assume the standard deviation of crude oil futures and spot jet fuel price is 6% and 3%, respectively. Therefore, the minimum variance hedge ratio is 0.475, or (0.95 * (3% / 6%)). The NYMEX Western Texas Intermediate (WTI) crude oil futures contract has a contract size of 1,000 barrels or 42,000 gallons. The optimal number of contracts is calculated to be 170 contracts, or (0.475 * 15 million) / 42,000. Therefore, the airline company would purchase 170 NYMEX WTI crude oil futures contracts.