448 Planning and Forecasting size and direction of the cash flows are determined by an agreed upon formula spelled out in the swap agreement—a formula that is contingent on the perfor- mance of other underlying instruments. Due to this contingency on other un- derlying assets, swaps are considered derivatives. One easy type of swap to understand is the equity swap. Suppose Back Bay Investment Management owns a large block of Standard & Poor’s 500 stocks. Suppose another firm, Capital Bank owns a large block of NASDAQ stocks. Back Bay would like to diversify into NASDAQ stocks, and simultane- ously Capital Bank would like to diversify into S&P 500 stocks. The old fashion way of achieving the desired objectives would be for each party to sell the stocks they do not want, and reinvest the proceeds in the stocks they do want. Such an approach is very expensive in terms of commissions. A much cheaper alternative is for each party to keep their own portfolio intact, and arrange be- tween themselves an equity swap. The swap agreement might dictate the following terms. For every per- centage point that the NASDAQ stock index rises over the course of the year, Capital Bank will pay Back Bay Investment Management $1 million. Simulta- neously, for every percentage point that the S&P 500 rises over the course of the year, Back Bay will pay Capital $1 million. Thus, if the NASDAQ index rises 15% and the S&P 500 rises 11%, there will be a net payment of $4 million from Capital to Back Bay. If in the following year the NASDAQ index rises 23% and the S&P 500 rises 29%, Back Bay will pay Capital $6 million on net. The equity swap is illustrated in Exhibit 13.5. In this equity swap, the “notional principal” is $100 million—that is, the payments equal a base of $100 million times the indexes’ respective returns. The net effect of the swap is to essentially convert $100 million of Back Bay’s Standard & Poor’s stocks into $100 million of NASDAQ stocks. Simultaneously, $100 million of Capital Bank’s NASDAQ stocks will now perform as if they were $100 million of Standard & Poor’s 500 stocks. Both sides keep their assets parked where they were, but they swap exposures on the notional principal. Some arithmetic will prove the point that Back Bay’s portfolio will now perform as if it were invested in NASDAQ stocks instead of S&P stocks. If Back Bay did in fact own $100 million of NASDAQ stocks, by the end of the first year, after the 15% rise in NASDAQ stocks, this portfolio would have EXHIBIT 13.5 An equity swap. Back Bay Investment Management Capital Bank Returns on $100 million of NASDAQ stock index Returns on $100 million of S&P 500 stock index Financial Management of Risks 449 grown to be worth $115 million. But Back Bay owns $100 million of S&P stocks, and has a position in an equity swap. The $100 million of S&P stocks grows to $111 million after the 11% S&P rise in the first year. The swap, how- ever, pays Back Bay $4 million at the end of the first year. Thus, at the end of the first year, Back Bay does have $115 million in total portfolio value. Verify, that the total value of Capital Bank’s portfolio at the end of the first year will be $111 million, just as if it had invested $100 million in S&P stocks. Since the notional principal remains fixed at $100 million, the swap will continue to convert $100 million of Back Bay’s S&P stocks into $100 million of NASDAQ stocks, and visa versa for Capital Bank. Total portfolio performance in subsequent years depends on how the swap proceeds are reinvested by each party. Interest Rate Swaps The most common type of swap is an interest rate swap. The typical, or “plain- vanilla” interest rate swap, is a “fixed for floating swap,” whereby cash flows depend on the movement of variable interest rates. For example, consider two firms Michel/Shaked Manufacturing (M) and Healing Heart Hospital (H). The swap agreement might specify that M pay H a fixed 10% per year on a notional principal of $100 million, and H pays to M the prime rate, as quoted in the Wall Street Journal, times $100 million. Settlement might be once per year. The prime rate quoted at the beginning of each year will determine the cash flow paid at the end. Thus, if at first the prime rate is 12%, H will pay M $2 million at the end of the first year. If by the end of the first year the prime rate has fallen to 7%, at the end of the second year M will pay H $3 million. And so the swap continues for a specified number of years. H will benefit if rates fall; M will benefit if rates rise. This interest rate swap is depicted in Exhibit 13.6. Examples of Hedging Interest Rate Exposure with a Swap The Keating Computer Company assembles and markets computer hardware systems. In the past several years Keating Computer has been one of the fastest EXHIBIT 13.6 An interest rate swap. Back Bay Investment Management Capital Bank Variable interest rate × $100 million Fixed 10% interest rate × $100 million 450 Planning and Forecasting growing computer hardware companies. They borrowed extensively to finance this growth. Currently on the books is a very large long-term variable rate loan. Also on the books is a sizable amount of short-term debt. The managers of Keating Computer have observed that they are dangerously exposed to interest rate risk. If rates should rise, they will have to pay more in debt service on the variable rate loan, and they will face higher interest rates when they roll over their short-term debt. The company is currently profitable, but they worry that rising interest rates can wipe out that profit. Since the company is planning an equity offering in coming years, management is very concerned about the prospect of reporting any losses over the near term. One solution to Keating Computer’s problem would be to refinance at fixed interest rates. The transaction costs of refinancing, however, are sizable, and the rates currently offered on long-term debt are not favorable. Entering an interest rate swap is a better hedging strategy. The company should enter as the fixed rate payer, which means they would be the variable rate receiver. As interest rates rise, the company will make money on the swap, offsetting the higher payments they must make on their own debt. Since swaps are over-the- counter instruments, the company can tailor the terms of the swap so that the hedge will be in force for the exact number of years it is needed. Moreover, the notional principal can be tailored so that the money received when rates rise is closely matched to the new higher debt service obligations. Another Example Kayman Savings and Loan holds most of its assets in the form of long-term mortgages, mortgage backed securities, and 30-year Treasury bonds. The lia- bilities of Kayman Savings are mostly short-term certificates of deposits. Kayman has also sold some short-term commercial paper of its own. Stephen Kayman, the president of Kayman Savings, suddenly realizes that they are in the same precarious predicament as that of many savings and loans (S&Ls) that went bust in the 1980s. Long-term fixed income instruments are more sensitive to interest rates than short-term instruments. When interest rates rise, both long-term and short-term instruments fall in value, but the long-term instru- ments fall much more. Consequently, if interest rates should rise, the market value of the S&L’s assets will fall farther than the market value of its liabili- ties. When this happens, the S&L’s equity will be wiped out. The bank will be bankrupt. Even if government auditors do not shut down the S&L, the institu- tion will experience cash flow problems. The relatively low fixed interest rev- enue from the long-term assets will not be enough to keep up with the rising interest expenses of the short-term liabilities. What can Kayman do to protect against the risk of rising interest rates? The predicament faced by Kayman Savings is known as a “duration gap.” The duration of the assets is greater than the duration of the liabilities. As rates rise, equity vanishes. Kayman Savings needs a hedge that will pay off when rates rise. Entering an interest rate swap as the fixed payer can close the Financial Management of Risks 451 duration gap. The swap will grow in value as rates rise, offsetting the equity losses. Again, the size, timing, and other terms of the interest rate swap can be tailored to meet the particular needs of Kayman Savings. HOW TO CHOOSE THE APPROPRIATE HEDGE We have now examined forwards, futures, call options, put options, and swaps. We have observed how these instruments can be used to hedge in a wide vari- ety of risky scenarios. How does one choose which of these instruments to use in a particular situation? When is a future better than a forward? When should an option be used instead of a future? Should interest rate exposure be hedged with bond futures or swaps? The following steps will provide some guidance. The first task in implementing a hedge strategy is to identify the natural exposures that the firm faces. Does the firm gain or lose when interest rates rise? Does it gain or lose as the dollar appreciates? Is a falling wheat price good news or bad news for the company? What about oil prices and stock prices? How about foreign stock and bond prices? Is the company exposed, and if so, which direction causes a loss? Clearly the answers to these questions vary from firm to firm. The bak- ers benefited from falling wheat prices while the farmers suffered. Rising in- terest rates might hurt a firm that has variable rate debt, but might help a pension fund that is about to invest in bonds. A rising dollar benefits U.S. im- porters but hurts U.S. exporters. The first step in risk management is to iden- tify the exposures. Once the exposures are identified, one should narrow the search for an appropriate hedge to the set of derivatives that compensate the firm when the adverse scenario is realized. For example, an airline that purchases jet fuel will see higher costs when the price of oil rises. The airline should look for deriva- tives that pay off when oil prices rise. Thus, the airline should consider a long position in an oil future, or a long oil forward, or an oil call option. A bank that suffers losses when interest rates rise should consider a short position in a bond future or forward, bond put options, or the fixed-payer side of an interest rate swap. An exporter that expects to receive Mexican pesos, might wish to go short in peso futures or forwards, or buy peso puts. The next step is to choose from among futures, forwards, options, and swaps. This is perhaps the trickiest part of the analysis. To guide the selection, it is helpful to categorize the risks and the instruments as either symmetric or asymmetric. Futures, forwards, and swaps are symmetric hedging instru- ments, in that they pay off money if prices move in one direction, but incur losses if prices move in the opposite direction. Options, on the other hand, are asymmetric hedging instruments. They pay off money if prices move in one di- rection, yet result in no cash outflows if prices should move the other way. A symmetric risk is one in which the firm is hurt if underlying prices move one way but benefits if prices move in the opposite direction. An asymmetric risk 452 Planning and Forecasting is one in which the firm is hurt if prices move in one direction, but the firm does not benefit appreciably if the price moves in the other direction. For ex- ample, a firm that exports to Japan and receives payment in yen benefits when the value of the yen rises, but is hurt when the yen falls in value. This foreign exchange risk is thus symmetric. The symmetric foreign exchange risk can be eliminated most completely with a symmetric instrument such as a future or forward, not an option. A portfolio manager invested in stocks also faces a symmetric risk. He benefits if stock prices rise, and loses money if stock prices fall. The portfolio manager, however, might wish to modify the exposure in an asymmetric way, insuring against losses on the downside while maintaining the potential for upside appreciation. An asymmetric instrument, a put option, would be the ap- propriate hedge instrument in this case, since an asymmetric instrument con- verts a symmetric risk into an asymmetric exposure. An automobile leasing company is an example of a commercial venture that faces an asymmetric risk. If interest rates rise, the firm’s interest expenses rise. If the firm tries to offset these higher costs by charging higher prices to customers, the firm will lose business. However, if interest rates fall, buying an automobile on credit becomes a more attractive substitute for leasing unless the leasing company also lowers its prices. Thus, the leasing company suffers when rates rise, but does not benefit when rates fall. An asymmetric hedge, such as a bond put option would be the best choice of instrument in this case. The bond put option will pay off when rates rise, but will not require a cash outflow when rates fall. The key to choosing between symmetric and asymmetric instruments is to first identify the nature of the risk that is faced, and then choose the type of instrument which will modify the risk appropriately. A symmetric risk can best be eliminated with a symmetric instrument. An asymmetric risk can best be eliminated with an asymmetric instrument. A symmetric risk can be turned into an asymmetric exposure with an asymmetric instrument. Finally, the last step is to choose whether the instruments should be of the exchange-traded or over-the-counter variety. Forwards and swaps are over- the-counter instruments; futures are exchange-traded instruments. Options are generally exchange-traded, but they can also be bought over the counter. Exchange-traded instruments are standardized, and are thus liquid and entail low transaction costs. But since they are standardized, they may not perfectly suit the risk exposure the firm wishes to hedge. Over-the-counter instruments can be custom tailored, but they are therefore less liquid and more expensive in terms of transaction costs. The firm must weigh the costs and benefits of liquidity, differences in transaction costs, and custom fit. The correct choice depends on the particular hedging situation. A couple of examples will illustrate the process of putting all the factors together to pick the best suited hedge. A U.S. manufacturing firm owns a pro- duction facility in Canada. Rent and wages are paid in Canadian dollars. Con- sequently, if the Canadian dollar rises in value, the wages and rent translated Financial Management of Risks 453 into U.S. dollars would become more expensive. If the Canadian dollar falls, the expenses in terms of U.S. dollars decline. Thus, the exposure is symmetric. If the firm wishes to completely eliminate the exposure, a symmetric instru- ment is called for, ruling out options. The firm should go long in Canadian dol- lar futures or forwards, since either of these instruments will provide positive cash flows when the Canadian dollar is rising. An exchange-traded Canadian dollar futures contract is available. The commission on the forward is greater than the commission on the futures, but the futures contract covers slightly more Canadian dollars than the firm wishes to hedge, and the timing does not exactly correspond to the timing of wage and rent payments. An over-the- counter forward contract could be constructed so that cash flows are synchro- nized with wage and rent payments. After weighing the two alternatives, the managers decide that the benefit from lower commissions on the futures con- tract outweighs the disadvantage of the futures’ slight mismatch in the hedge. They go long in Canadian dollar futures. The same manufacturing firm has many customers in Venezuela. If the Venezuelan currency (the bolivar) falls in value, the U.S. dollar value of the revenue will fall. If the Venezuelan currency rises in value, the dollar revenue will rise. Thus, the risk is symmetric, and so the list of hedging candidates is narrowed to futures and forwards. The firm benefits from a rise in the bolivar, and loses when the bolivar falls. Thus, the firm should go short in bolivar fu- tures or forwards, so that a cash flow will be received when the bolivar falls. No bolivar futures contracts are available on exchanges, so the firm must go short in over-the-counter Venezuelan bolivar forwards. A producer of copper wire purchases large amounts of copper as a raw material. When copper prices rise, the firm must either absorb the higher ex- penses, or raise the price of copper wire. Raising the price of wire, however, causes customers to cut back on purchases, and so the firm is stuck with unsold inventory. When copper prices fall, alternatively, competitors lower their prices and so the firm must also lower its price in order to sell its output. Con- sequently, the firm’s profits suffer when copper prices rise, but profits do not increase when copper prices fall. Management would like to increase produc- tion capacity, but it is difficult to forecast how much the firm can sell, given re- cent copper price fluctuations. With current levels of raw copper inventory, management believes that raw copper prices can rise as much as 10% without significantly impacting the firm’s bottom line. What is the appropriate hedge? Clearly, the firm faces an asymmetric risk. The firm is hurt when cop- per prices rise, but does not benefit when the price falls. An option will best mitigate the risk. Since the firm is hurt when copper prices rise, a call option that pays off when copper prices rise is the best choice. Since the firm can tolerate a 10% rise in copper prices without suffering significant losses, an out-of-the-money copper call option that begins to pay off only when copper prices rise more than 10% is ideal. Exchange-traded copper call options exist, and so due to their greater liquidity and lower transaction costs, they would be the best choice. 454 Planning and Forecasting A cellular communications firm has sold a six-year variable rate bond, where the interest payments are tied to the London Interbank Offered Rate (LIBOR). When LIBOR rises, so too do the company’s interest payments. When LIBOR falls, the firm’s interest payments fall. The company’s interest payments are due twice a year, on the last days of February and August. The firm raised $160 million this way. With competition holding cellular telephone rates down, the firm worries that an increase in interest rates can wipe out all profits. What is the appropriate hedge instrument? The interest rate exposure is symmetric, ruling out options. The firm needs an instrument that will pay it money when interest rates rise. Thus, the firm should go short in either bond futures or forwards, or the firm should be the fixed-rate payer in an interest rate swap. Since the cash flows that the firm is trying to hedge do not conform to those of any exchange-traded future, the correct choice is narrowed to the over-the-counter instruments—a forward or a swap. The firm must hedge twelve interest rate payments, two per year for six years. Forwards are generally constructed to provide one payment only. Swaps are designed to hedge multiple payments over longer terms. Thus, entering a six-year interest rate swap as the fixed payer is the ideal hedge in this situation. SUMMARY AND FINAL RECOMMENDATIONS This chapter has presented the basics of risk management using derivatives. By separating an asset’s value from its exposure, derivatives allow firms to ex- change exposures without exchanging the underlying assets. It is much more economical to transfer exposures, rather than assets, and thus derivatives have greatly facilitated risk management. Derivatives are indeed powerful risk man- agement tools, but in the wrong hands they can be dangerous and destructive. It is essential that managers fully understand how much and under what condi- tions derivatives will provide positive cash flows or require cash outflows. If it is not absolutely clear when and how much the cash flows will be, do not enter the contract. Managers should strive to identify the nature, magnitude, and size of their risk exposures. They can then match those exposures with coun- tervailing positions in derivatives. Managers should never forget that their job is to preserve value by reducing risk. The temptation to speculate should be avoided. Don’t be greedy. FOR FURTHER READING Abken, Peter, and Steven Feinstein, “Covered Call Options: A Proposal to Ease Less Developed Country Debt,” in Financial Derivatives: New Instruments and Their Uses (Atlanta: Federal Reserve Bank of Atlanta, 1994). Bernstein, Peter, Against the Gods: The Remarkable Story of Risk (New York: John Wiley, 1998). Financial Management of Risks 455 Bodie, Zvi, and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice-Hall, 2000). Chance, Don M., An Introduction to Derivatives (New York: Dryden Press, 1998). Chew, Lillian, Managing Derivative Risks: The Use and Abuse of Leverage (New York: John Wiley, 1996). Daigler, Robert T., Financial Futures and Options Markets: Concepts and Strategies (New York: HarperCollins, 1994). Dunbar, Nicholas, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It (New York: John Wiley, 2001). Fraser, Andrew, “Top Banks Plan Bailout for Fund,” Associated Press, September 24, 1998. , “Fed Key Player in Rescue of Floundering Hedge Fund,” Associated Press, September 25, 1998. Hull, John C., Options, Futures, and Other Derivative Securities (Upper Saddle River, NJ: Prentice-Hall, 2000). Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000). Various authors, “Managing Risks,” special report in Business Week, October 31, 1994, 86–104. NOTES 1. Zvi Bodie and Robert C. Merton, Finance (Upper Saddle River, NJ: Prentice- Hall, 2000) deserve credit for this perspective on risk management techniques. 2. Fischer Black, who helped invent the model, passed away prior to recognition from the Nobel committee. 3. All data referring to equity positions, assets under management, exposure, and profits and losses in this section come from Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000). PART THREE MAKING KEY STR ATEGIC DECISIONS . into S&P 500 stocks. The old fashion way of achieving the desired objectives would be for each party to sell the stocks they do not want, and reinvest the proceeds in the stocks they do want. Such. want. Such an approach is very expensive in terms of commissions. A much cheaper alternative is for each party to keep their own portfolio intact, and arrange be- tween themselves an equity swap. The swap. portfolio performance in subsequent years depends on how the swap proceeds are reinvested by each party. Interest Rate Swaps The most common type of swap is an interest rate swap. The typical, or