market. The size of the spread or the differencebetween their yields reflects the market’s perception of the creditworthiness of thesecurity. A narrow spread indicates that the market judges the security to be closer
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in credit quality to the Treasury note. A wide spread indicates the market believesthe related securities are a more risky investment than a Treasury note.Money fund managers, cash management funds, and mutual funds all arepotential users of the T-bill, bond, and note futures. The manager of a money fundwhose cash investments are in various types of money market instruments such asCDs, commercial paper, T-bills, etc., can effectively use a futures contract in threemonth T-bills, or Eurodollars. By anticipating the size and approximate dates ofinvestment in these and other money marketing vehicles, the fund manager can buythe number of contracts necessary to cover some part of the future interest rate exposure and thereby lock in an acceptable return on at least part of his portfolio.
CROSS-HEDGESMost hedges are cross-hedges. That is, one is not using exactly the same futurescontract with the same coupon, maturity, creditworthiness etc., as the basic earlyinstrument being hedged. So the hedger must:a. Determine the appropriate futures contract to use as the hedge. This isusually done through correlation analyses and comparison of liquidity inthe various futures contracts.b. Determine the appropriate number of futures contracts to use. This isdetermined by two things:(i) The relationship between movements in the underlying exposure beingconsidered and the price of the futures contract being used.(ii) The effect of a one-unit change in the price of the underlying exposure compared to the effect of this one-unit change in the price of thefutures contract.
FACTORS AFFECTING RATESYields on Eurodollars and T-bills can fluctuate rapidly as money market conditions change. What makes interest rates fluctuate from day to day? What economicfactors can affect the money market? These questions and many more are of greatimportance to anyone dealing in interest-rate-sensitive instruments.Among the most important economic factors affecting money market interestrates are (1) Federal Reserve activities; (2) financial needs of the business community; (3) international currency movements, both speculative and trade-related; (4) thetechnical tone of the money market; and (5) the general condition of the economy.232
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Federal Reserve ActivityBy far the most important determinative of money market rates is the FederalReserve system. In the previous chapter, we explained the role the Federal Reserveplays in the overall economy; and we explained, albeit briefly and simplistically,that the Federal Reserve has essentially three tools available to affect interest rates:First, its Open Market Committee operations, through which it buys and sellsgovernment securities, influences interest rates and the availability of credit. Whenthe Fed buys securities from the commercial bank, it results in an increase in loanable funds and a decrease in interest rates. When the Fed sells securities, the buyer’sreserve account is debited. This results in a reduction of credit and a firming of interest rates.Second, the Fed has a far-reaching monetary impact through its control overmember bank reserve requirements. It can set them anywhere between 10 percentand 22 percent. These reserves directly affect the availability of loanable fundsand, indirectly, the interest rates.Third, the Federal Reserve sets an interest rate called the discount rate. Thisis the interest rate that banks must pay the central bank when a commercial bankdecides to borrow money in order to maintain its reserves. Changes in the discount rate often are regarded as indicating fundamental shifts in the Fed creditpolicy. Such shifts are immediately reflected by the financial market, sometimeseven anticipated by it. Changes in the discount rate set up a virtual chain reactionthroughout the financial market. When the discount rate is increased, banks are generally inclined to sell government securities, especially T-bills, rather than expandtheir borrowings at the Federal Reserve discount window. The sale of securitiesreduces security prices while raising their yields, and higher yields in the T-bill market spread to other money market instruments and are reflected across the boardin higher interest rates. The opposite occurs when the discount rate is lowered.
Business NeedsIndustry’s demand for cash has a strong influence on short-term interest rate movements. As the demand for loans increases, interest rates generally rise. On the otherhand, if loan demand begins to lag because of a slowdown in the general economy,one would expect downward pressure on interest rates. Indicators of short-termbusiness loan demand include new orders in durable goods industries, contractsand orders for new plants and equipment, changes in the book value of inventories,industrial production, and levels of commercial and industrial loans outstanding.
Dealer ActivityAnyone who desires to trade interest rate futures should become familiar with theactivity of dealers in government securities. At the present time, there are approximately233
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20 active government security dealers. The activity and aggressiveness of dealers inbidding on and offering government securities affects the direction and volatility ofall interest rates. These dealers are continuously interpreting the Fed’s actions, thenation’s economic well-being, and social and political events to determine the impactthat such things have on prices. One should watch closely what these cash marketdealers are doing.
General Economic ConditionsIn the previous chapter we discussed some of the significant indicators of the condition of an economy. A stable economic situation helps create stable money market conditions, while a period of economic uncertainty usually leads to wide interest rate fluctuations. Such measures of economic conditions as the rate of growthin GNP, balance of trade, levels of unemployment, inflation, housing starts, etc.,help determine the strength or weakness of the economy. Some of these factors andan interpretation of them are encompassed in the preceding chapters. A regularweekly, monthly, and quarterly cycle of economic information releases is followedby most government agencies, the Fed, the Treasury, etc. These releases oftenshow substantial price volatility.
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Hedging Applications forInterest Rate Futures
The preceding chapters on currency and interest rate futures contain most of thebasics you need to start understanding how these markets work. Examples in thosechapters also give you a general idea of how those markets can be used for hedging.This chapter provides a slight elaboration of some of the more practical applicationsof hedging, which will aid the interested reader in exploring these concepts furtherand in devising new means of application. The chapter starts by setting forth a framework for helping decide whether the cost of hedging is worth it. After that, the chapter enumerates typical circumstances that would lead a person to consider a hedge.
TO HEDGE OR NOT TO HEDGEHedging is not always worth it, or, to paraphrase the English, the game may notbe worth the candle. One has to look at expected costs and expected benefits. Theseexpectations change as situations change and new information emerges.235Copyright 2001 The McGraw-Hill Companies. Click Here for Terms of Use.
Chapter 24
In any hedging decision the manager must answer three very important questions:1. What is the net exposure?2. What is the probability of a loss as a result of this risk exposure?3. Which of the alternative methods available to me for managing this riskwill provide the most complete coverage at the least cost and fit our corporate mission?The following section focuses on currency risk and hedging for convenienceof illustration. The concepts and methodology apply equally well to other commodities and financial instruments.
What Is the Net Risk ExposureNet risk exposure refers here to the amount of money that would be lost if theprice changes. Price may be an exchange rate, an interest rate, a price per barrelof oil or per bushel of wheat, etc. It is an objective measure of the impact a devaluation or revaluation will have on the value of a firm’s assets and liabilities orinputs and outputs. If a currency is devalued, any liability (such as loans) a foreignfirm owes in that currency can be paid back with cheaper money. Conversely, if ithas been revalued, the currency needed to pay back that loan will cost more.Calculating the net risk exposure is one of the most useful exercises a manager can do and, perhaps more than anything else, is the key to successful riskmanagement. The exercise often forces managers to look at their business and corporate mission in a whole new light and yields benefits even if they never enter intoa futures hedge.There are a variety of ways by which the net risk exposure can be calculated. Current assets in a currency minus current liabilities in that currency is onevery simple but probably incomplete way. Most firms today use a more sophisticated procedure that takes account of such things as receivables booked, liabilitiesincurred, and the method by which the balance sheet values are converted from onecurrency to another and, most important, the timing of the repricing. This is a verycomplex topic on which whole books can be and have been written. Suffice it tosay, before you venture into this area, get your accountant’s advice. A thoroughunderstanding of accounting rules and tax laws is of key importance in estimatingtrue risk exposure.
What Is the Probability of Loss on Net ExposureThis is a subjective evaluation that should be based on an analysis of the economicand political information available about a country or a product. In making this deter-
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mination, the manager should first estimate the probability that there will be achange in the exchange rate or price. Is there a 50 percent chance that the currency of concern will be devalued this month? This year? An 80 percent chance? And,second, estimate the probability of the size of change in the exchange rate. Will itbe 10 percent? 20 percent? 30 percent? Or even 40 percent? These may only be good“guesstimates,” but they need to be made. In fact, they are automatically made bythe decision-maker whether he does it consciously or unconsciously.
Hedge Yes, Hedge NoArmed with these pieces of information—net exposure, probability of loss, andprobability of size of loss—you can then calculate the expected value of a loss tothe firm by multiplying the probability of a loss times the probability of the sizeof the loss. See Steps a, b, c, and d in Table 24.1. Once you have that answer, youare then in a position to compare the expected value of the loss (this is calculatedby multiplying the probability of a loss by the probable size of the loss) to your costof hedging.Ultimately, a manager needs to ask, “Which of the alternative methods available, singly or in concert with another alternative, will provide the most completecoverage of the risk at the least cost?” Generally, managers have a number of alternative hedge vehicles available to them. They can self-protect through variousmanagement techniques (diversification, prepayments or delayed settlements, etc.);they can hedge by going to their banks (or dealers) and obtaining a forward contract or a swap or option contract; or they can hedge on a futures contract. In making this determination, they must examine the cost of each alternative.The cost of the hedge includes not just the commission cost, the interest foregone (if any) on the margin for the futures contract, and the bid-ask spread, but alsoany premium or discount that is reflected between the futures contract and theexpected spot price. For example, if your expected spot price is 3 percent under theTable 24.1 Hedge Decision Modela. Net exposure . . . . . . . . . . . . . . . . . . . . . . $10,000,000b. Probability of loss. . . . . . . . . . . . . . . . . . . . . . . . . 50%c. Probable size of loss. . . . . . . . . . . . . . . . . . . . . . . 10%d. Mathematical expectation of loss (b × c). . . . . . . . . 5%e. Cost of hedge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3%f. Decision—compare d to e. If d is greater than e, hedge.If d is less than e, do not hedge.
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six-month forward price, the “cost of the buy hedge” includes that 3 percent premium. If the cost of the hedge is less than the expected loss, hedge; if the cost isgreater, don’t.Cost of Hedge orFutures Price – Spot Price12× 100 ×Forward Premium =Spot Pricemonths to maturityor DiscountTo demonstrate, assume that the manager of a firm calculates his net exposure as $10 million based on an expected devaluation of the U.S. dollar relative tothe German deutschemark. Secondly, assume that given his evaluation of the economic situation in Germany, he expects the probability of a loss to be 50 percent.In other words, he believes that there is a 50/50 chance that the devaluation of theU.S. dollar relative to the deutschemark will occur by the next year. Assume alsothat he calculates the probability of the size of the devaluation to be 10 percent.Table 24.1 offers a summary of the situation and a way to determine whetherto hedge:In the example above, the firm would make the decision to hedge becausethe mathematical expectation of a loss exceeds the cost of hedging, 5 percent versus 3 percent. If those expectations are correct, the firm would gain 2 percent byhedging. Note that the key to the decision of whether to hedge is found in correctcalculation of the probabilities. If the probabilities were different, the mathematical expectations also would be different.A caveat: One should not enter into a hedging transaction without considering the tax implications and the effects on cash flows. Any business firm that isengaged in foreign exchange transactions would do well to integrate its hedgingtransactions and its accounting decisions in order to ensure it gets the maximumnet benefit of its risk management efforts.
HEDGE RATIOS—DOLLAR EQUIVALENCY—AND THEMATURITY ADJUSTMENTThe hedge ratio refers to the number of futures contracts one needs in order to getan effective hedge. An effective hedge is one where the dollars gained or lost inthe futures position are equal but opposite to the dollars gained or lost in the cashmarket (portfolio, new investment opportunity, balance sheet, etc.).As noted earlier, the value of a one-point move (1/100 of 1 percent) in theyield of a T-bill futures contract is $25. This is derived from the fact that T-billfutures represent 90-day maturities. A one-year T-bill will have an equivalent value
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of $100 for each .01 percent movement in yield. Thus, the following value relationships hold:.01% for 90 days $25.01% for 180 days $50.01% for 240 days $75.01% for 360 days $100The value of .01 percent over time becomes very important in hedging. Forexample, if you were trying to hedge a six-month loan by using 90-day T-billfutures, you would need to use twice as many “dollars worth” of futures contractsto get the equivalent movement in value between the cash position and the futuresposition. Each .01 percent movement in yield in the cash position would be worth$50, while each .01 percent movement in a single futures position would be worthonly $25. Therefore, you need two futures contracts to give equal dollar valuechange.The calculation of the hedge ratio for bonds, notes, and other fixed couponinstruments is more complex. It involves calculating the “duration” of the futuresand the “duration” of the instrument being hedged, given small changes in interest rates. Duration is a fancy financial term for volatility1. It is not the life span ofthe bond. The ratio of the duration of the futures to the duration of the instrumentbeing hedged equals the correct hedge ratio. As interest rates change, these ratioschange. Thus, hedges must be continually adjusted. In addition, as noted in Chapter26, the delta, gamma, vega and theta are associated with options trading and alsoimportant for calculating the correct hedge ratio.Hedge ratios also are affected by things other than maturity. In most cases,the basic hedge ratios estimated by the above procedures are further adjusted bya regression or correlation coefficient.For non-financial hedges, such as most agricultural commodities, hedgeratios derived from regression or correlation analysis will suffice. In many cases,those ratios will approximate 1.00.One can get very involved in doing precise calculations of hedge ratios andfind that the effort is not worth it, because the adjustments are too small to bemeaningful or else so frequent, in both directions, as to be self-defeating (e.g.,whipsawing back and forth). Thus, settling on a simple, easily calculated procedure that reflects true average relative value changes over the life of a hedge is probably the most common and sensible approach.
1.
The formula for calculation is too complex for presentation here. For a thorough explanation ofit, see Powers, Mark J. and Mark Castelino, 1991. Inside the Financial Futures Markets. NewYork: John Wiley & Sons.
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HEDGING—CURRENCYIn earlier chapters we discussed the concept of hedging and demonstrated its application to some of the traditional agricultural commodities. These same conceptsapply to the foreign currency hedger.The following examples illustrate some potential hedging situations availableto different sectors of the economy.
The Buy HedgeAssume a Chicago tractor maker has a Swiss plant that is doing very well and hasaccess to funds in the form of Swiss francs. It has no need for those funds until Swisstaxes are due in six months. At the same time, assume that the Chicago tractormaker has an engine plant in Milwaukee that is in need of a short-term loan tomeet operating expenses. The best move for the tractor maker may be to transferthose funds from the Swiss plant to the Milwaukee plant for six months. In thetransaction, the hedger would sell the spot Swiss francs for dollars and buy Swissfrancs for future delivery, thus establishing a buy hedge. Table 24.2 shows thesummary of these transactions.In this example the hedger had a $1,500 loss in the cash market that wasmore than offset by a $1,950 gain in the futures market. The hedger’s basis declinedfrom 100 points to 10 points for a net decline of 90 points. Each point is worth $1.25or $112.50 for each contract, or a total of $450.
Table 24.2 Swiss Franc Buy HedgeCash MarketMarch 1Sell 500,000 Swiss francsfor $.50000/SF = $250,000
Basis
Futures Market
100
Buy four September Swiss francfutures, 125,000 SF each at $.49900= $249,500
September 1Buy 500,000 Swiss francs at$.50300/SF = $251,500
10
Sell four September Swiss franc futurescontracts, 125,000 SF each at $.50290= $251,450
Loss = 300 points ($1,500)
90
Gain = 390 points ($1,950)
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The Sell HedgeAssume a Chicago bank has excess funds to invest in the short term, and the highest short-term interest rate currently is being paid in Canada. Let’s say 91-dayCanadian Treasury bills are yielding 8.5 percent, and U.S. Treasury bills are yielding 7.5 percent. The Chicago banker will buy Canadian dollars in the spot market,transfer them to his Canadian banking correspondent and direct that person to purchase 91-day Canadian Treasury bills. At the same time, he will sell Canadian dollars in the futures market for delivery three months hence. The amount of theCanadian dollars he sells in the futures market will include the original number plusenough to cover the interest that will accrue.The advantage of this hedge is that the banker will have fixed his sellingprice for the Canadian dollars 91 days from now. This way he can be assured thatthe interest in Treasury bills will not be lost in the conversion back to dollars, ifthe price of Canadian dollars goes down during the period. The transaction is summarized in Table 24.3.In this example, if the banker had not hedged, he would have lost nearly halfof his interest income ($8,423.10) when he changed his Canadian dollars back toU.S. dollars because the spot price of the CD went down. However, by hedging inthe futures market he actually recovered all of his interest income in the futures
Table 24.3 Canadian Dollar Sell HedgeCash MarketDecember 1Buy 191,000 Canadiandollars at $1.00000 =$191,000
Basis
Futures Market
100
Sell two CD contracts,March delivery,$100,000 each at$1.00100 CD = $200,200
March 1Sell 191,000 CD at$.98000 CD = $187,180
10
Buy two CD March futures deliveryat $100,000 each $.98010 CD =$196,020
Loss = 2,000 points ($4,000)
90
Gain = 2,090 points ($4,180)
Interest Accrued $8,423.10
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transaction and made an overall profit of $180 on the hedge as well ($4,180 – $4,000= $180). he could just as easily have lost a small amount. The important point is thatthe hedge protected his interest income from the exchange risk. His basis declinedfrom 100 points futures over cash to 10 points futures over cash, a net decline of90 points. Each point for each contract is worth $1. Because he had two contracts,each point is worth $2 for a total of $180.The world monetary system is in a continual state of transition. As a result,the risk of doing business internationally is increasing right along with the increaseddemands for international trade. As more and more businesses and banks seekmeans of protecting themselves from currency losses due to exchange fluctuations, the role of foreign currency hedging will undoubtedly grow in importance.The currency futures markets can be used by a wide variety of commercialinterests. The following are just a few categories in which futures hedging couldbe helpful:1. Companies building plants abroad.2. Companies financing subsidiaries.3. Manufacturers importing raw materials and exporting finished products.4. Exporters taking payment in foreign currency.5. Companies dealing in goods bought and sold in foreign countries.6. Companies abroad financing operations in Eurocurrencies.7. Stock purchases or sales in foreign countries.8. Purchases or sales of foreign securities.The possibilities are virtually limitless. Everyone who deals in or with foreign countries has a need for a hedging mechanism to avoid major losses due toexchange fluctuations.
APPLICATIONS OF AN INTEREST RATE FUTURES MARKETAny commitment in the money markets exposes both borrowers and lenders tothe risk of interest rate changes for as long as the debt instrument is outstanding.To minimize these risks, money market participants could hedge in the Eurodollarfutures market.As noted earlier, hedging is a method by which a borrower or lender of moneymarket funds buys or sells a futures contract as a temporary substitute for a borrowingor lending transaction to be made at a later date. Hence, the money manager or trust
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fund manager who knows he will be investing in Eurodollars in September mayestablish the yield on the September Eurodollars in July by entering the futuresmarket and buying the Eurodollar contract for delivery in September. The corporate treasurer who knows he will be borrowing money soon but needs time to workout his financial plan and actually get the loan arranged can hedge against higherrates by selling the futures.Builders, developers, and other users of short-term construction loans can usethe Eurodollar futures market to establish in advance the cost of borrowed money.Interest rates on short-term construction loans generally fluctuate with the primerate. An increase in the prime rate during the period of construction could push thecost of financing beyond the capacity of the borrower. This risk can be effectively removed by a short hedge.Hedging also can be used to protect against changes in the rates of othermoney market instruments such as commercial paper, certificates of deposit,bankers’ acceptances, etc. The effectiveness of the hedge will be determined by theextent to which movements in the rates for Eurodollars parallel movements inrates for the other instruments. For example, if a perfect correlation existed betweenmovements in Eurodollars and commercial paper, then a hedge in the Eurodollarfutures would be a very efficient device for protecting against changes in commercial paper rates. The closer the relationships, the more perfect the hedge.Even in instances where the correlation is not perfect and the basis is unstable but the volatility in both markets is high, an imperfect hedge will be much preferred over no hedge at all. For example, if it is normal for commercial paper totrade at a +25- to +150-point range over Eurodollars, one might think that aEurodollar futures would be a poor hedge mechanism for commercial paper rates,because a range of 125 points shows a significant amount of instability in the basis.However, if the volatility of Eurodollars and commercial paper is such that a 300point change in absolute rates is a highly probable occurrence, one could easily seethat the 125-point basis exposure that would accompany the hedge is much preferred over the 300-point exposure of the non-hedged position.Because the Eurodollar market is a rate from which many other movementsemanate, you can see that a Eurodollar futures contract can be an efficient vehiclefor hedging interest rate movements in other money instruments. You need onlycompare the volatility of the basis relationships to the relative volatility of theabsolute rates for each instrument to determine the efficiency and value of the hedge.
HEDGING AGAINST FALLING INTEREST RATESFinancial managers who anticipate having funds to lend (i.e., invest) in short-termmoney markets at a known time in the future can hedge against the risk that rates
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may drop in the interim. They do this by buying Eurodollar futures contracts. If interest rates go down between the purchase date and the delivery date, the contract willincrease in value. The futures contract’s appreciation in value should offset theinvestor’s “opportunity loss,” which resulted from the actual decline in interestrates during the period. A hedge minimizes both the downside risk and upsidepotential gain.
The Buying HedgeJudicious and selective use of the Eurodollar futures markets can help the corporate money manager match interest rates on borrowings and investments. It alsocan provide him with a view of market expectations on future interest rate levels.Such information is valuable in establishing the maturity mix in a portfolio.Let’s assume that on May 1 a corporate treasurer anticipating cash inflows forshort-term investment during the month of June observes that September Eurodollarfutures are selling at 93.00 (IMM index) to yield 7 percent. He feels this rate willfall during the next month or so to about 6.5 percent. Because the treasurer feels that7 percent is a very favorable yield and he wants to “lock in” that yield for his anticipated investment, he buys September futures. On June 15, when he has the cashavailable for investment, he buys Eurodollars maturing in December to yield 5.6 percent annually (IMM index of 94.00). This is 90 points lower than he expected. Atthe same time, on June 15, he lifts his hedge by selling his September futures at 94.08to yield 5.92 percent. The 108-point gain on the futures more than offsets the lowerthan-expected yield on the investment. The corporation will realize an additional .18percent yield return ($450 per million) on their Eurodollar investment as a result ofthe hedge. The futures provided flexibility in timing the forward pricing of theirinvestment yields. Table 24.4 explains this sequence of transactions.As another example, assume that in September a bank wanted to price inadvance the last three-month portion of a six-month asset that would be funded bya six-month Eurodollar liability. The bank would be interested in protecting againsta fall in interest rates from the period beginning the middle of December throughthe middle of March and would make the following transactions:1. In September, borrow six-month Eurodollars and, simultaneously, makea three-month loan.2. In September, buy one IMM Eurodollar contract for delivery in December.3. In December, receive the money from the maturing asset (loan) and re-lendthat money for three months at the then-current interbank rate; and simultaneously, sell (offset) one Eurodollar contract on the IMM. The proceedsfrom the futures should be applied to the new asset to get the net investment rate.
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Table 24.4 Hedging Short-Term Investment RatesCash MarketBasisMay 15Anticipated investment yieldof 6.5% (93.50 index)50June 15Buy $1,000,000 Eurodollar CDmaturing 12/24/96 @5.6% yield (94.40 index)32–90
18
Futures MarketBuy one September future @ 7%(93.00 index)Sell one September future @ 5.92%yield (94.08 index)+108
HEDGING AGAINST RISING INTEREST RATESBorrowers in the money markets also can use interest rate futures to protect themselves against increases in short-term rates with a “short” hedge, i.e., selling aEurodollar contract for future delivery. If rates rise, the value of the futures contract will drop, and the hedger can make a gain by buying it back for a lower price.
The Sell HedgeAssume a borrower plans on May 1 to sell $10 million in 90-day commercial paperin September. He expects to sell the paper at 5.5 percent. The current rate onSeptember futures is 5.2 percent. He can hedge that sale and ensure himself inadvance of the interest rate he will pay by taking a short position in the futures market (see Table 24.5).In this instance, had the borrower not hedged, he would have paid 1.13 percent more in interest costs than he originally expected. As it is, he paid .26 percentless. The futures provided the flexibility in timing the date on which he fixed hiscost. He did not have to wait until the day he came to market with the paper.As another example of a selling hedge, assume a money manager on June 15holds in inventory $5 million in Eurodollar CDs maturing in September yielding6 percent annually (IMM index of 94.00). The money manager knows that beforeSeptember 15 he will need the funds and will sell these Eurodollars to someone else.He can protect the selling rate and reduce his risk exposure by selling Septemberfutures contracts. Assume the September futures is at 93.35 (6.65 percent yield) fora basis of 65 points (see Table 24.6).
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Table 24.5 Hedging Commercial PaperCash MarketBasisMay 1Anticipates selling $10 millionof commercial paper. Expectedrate in September 5.5% (IMM30index 94.50)
Futures MarketSells 10 September Eurodollarcontracts at 5.2% (IMM index94.80)
September 5Sells $10