Forward and Futures Contracts
Finance Theory
Motivation
- Your company, based in the U.S., supplies machine tools to customers in Germany and Brazil. Prices are quoted in each countrya's currency, so fluctuations in the €/ $ and R / $ exchange rates have a big impact on the firm's revenues. How
can the firm reduce (or 'hedge') these risks?
- Your firm is thinking about issuing 10-year convertible bonds. In the past, the firm has issued straight debt with a yield-to-maturity of 8.2%. If the new bonds are convertible into 20 shares of stocks, per $1,000 face value, what interest
rate will the firm have to pay on the bonds?
- You have the opportunity to buy a mine with 1 million kgsof copper for $400,000. Copper has a price of $2.2 / kg, mining costs are $2 / kg, and you can delay extraction one year. How valuable is the option to delay? Is the mine
a good deal?
Exchange Rates, 1995 –2003
Caterpillar, 1980 –1989
Hedging or Speculation?
Alternative Tools?
- Futures, forwards, options, and swaps
- Insurance
- Diversification
- Match duration of assets and liabilities
- Match sales and expenses across countries (currency risk)
Should Firms Hedge With Financial Derivatives?
- "Derivatives are extremely efficient tools for risk management"
- "Derivatives are financial weapons of mass destruction"
View 1: Hedging is irrelevant (M&M)
- Financial transaction, zero NPV
- Diversified shareholders don’t care about firm-specific risks
View 2: Hedging creates value
- Ensures cash is available for positive NPV investments
- Reduces need for external finance
- Reduces chance of financial distress
- Improves performance evaluation and compensation
Examples:
Homestake Mining- Does not hedge because "shareholders will achieve maximum benefit from such a policy".
American Barrick- Hedges aggressively to provide "extraordinary financial stability...offering investors a predictable, rising earnings profile in the future".
Battle Mountain Gold- Hedges up to 25% because "a recent study indicates that there may be a premium for hedging".
Evidence
- Random sample of 413 large firms
- Average cashflowfrom operations = $735 million
- Average PP&E = $454 million
- Average net income = $318 million
57% of Firms Use Derivatives In 1997
- Small derivative programs
- Even with a big move (3σevent), the derivative portfolio pays only $15 million and its value goes up by $31 million
Basic Types of Derivatives
Forwards and Futures- A contract to exchange an asset in the future at a specified price and time.
Options (Lecture 10) - Gives the holder the right to buy (call option) or sell (put option) an asset at a specified price.
Swaps- An agreement to exchange a series of cashflowsat specified prices and times.