Principles of

Corporate Chapter 27
Finance
Risk Management
Seventh Edition

Richard A. Brealey
Stewart C. Myers

Slides by
Matthew Will

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Topics Covered
 Insurance
 Hedging With Futures
 Forward Contracts
 SWAPS
 How to Set Up A Hedge

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Insurance

 Most businesses face the possibility of a

hazard that can bankrupt the company in an
instant.
 These risks are neither financial or business
and can not be diversified.
 The cost and risk of a loss due to a hazard,
however, can be shared by others who share
the same risk.

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Insurance

Example
An offshore oil platform is valued at
$1 billion. Expert meteorologist
reports indicate that a 1 in 10,000
chance exists that the platform may
be destroyed by a storm over the
course of the next year.

? How can the cost of this hazard be

shared

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Insurance
Example - cont
An offshore oil platform is valued at $1 billion. Expert meteorologist
reports indicate that a 1 in 10,000 chance exists that the platform may
be destroyed by a storm over the course of the next year.
? How can the cost of this hazard be shared

Answer
A large number of companies with similar risks can each
contribute pay into a fund that is set aside to pay the cost
should a member of this risk sharing group experience the
1 in 10,000 loss. The other 9,999 firms may not
experience a loss, but also avoided the risk of not being
compensated should a loss have occurred.

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Insurance
Example - cont
An offshore oil platform is valued at $1 billion. Expert meteorologist
reports indicate that a 1 in 10,000 chance exists that the platform may
be destroyed by a storm over the course of the next year.
? What would the cost to each group member be
for this protection.

Answer

1,000,000,000
 $100,000
10,000

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27- 7

Insurance

 Why would an insurance company not offer a

policy on this oil platform for $100,000?

 Administrative costs
 Adverse selection

 Moral hazard

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Insurance
 The loss of an oil platform by a storm may be 1 in
10,000. The risk, however, is larger for an insurance
company since all the platforms in the same area
may be insured, thus if a storm damages one in may
damage all in the same area. The result is a much
larger risk to the insurer

 Catastrophe Bonds - (CAT Bonds) Allow insurers

to transfer their risk to bond holders by selling bonds
whose cash flow payments depend on the level of
insurable losses NOT occurring.

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27- 9

Hedging

Business has risk

Business Risk - variable costs
Financial Risk - Interest rate changes

Goal - Eliminate risk

HOW?
Hedging & Futures Contracts
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Hedging
Ex - Kellogg produces cereal. A major component and cost
factor is sugar.
 Forecasted income & sales volume is set by using a fixed
selling price.
 Changes in cost can impact these forecasts.
 To fix your sugar costs, you would ideally like to purchase
all your sugar today, since you like today’s price, and made
your forecasts based on it. But, you can not.
 You can, however, sign a contract to purchase sugar at
various points in the future for a price negotiated today.
 This contract is called a “Futures Contract.”
 This technique of managing your sugar costs is called
“Hedging.”

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Hedging
1- Spot Contract - A contract for immediate sale & delivery of
an asset.
2- Forward Contract - A contract between two people for the
delivery of an asset at a negotiated price on a set date in the
future.
3- Futures Contract - A contract similar to a forward contract,
except there is an intermediary that creates a standardized
contract. Thus, the two parties do not have to negotiate the
terms of the contract.

The intermediary is the Commodity Clearing Corp (CCC). The

CCC guarantees all trades & “provides” a secondary market
for the speculation of Futures.
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Types of Futures

Commodity Futures
-Sugar -Corn -OJ
-Wheat-Soy beans -Pork bellies SUGAR

Financial Futures
-Tbills -Yen -GNMA
-Stocks -Eurodollars

Index Futures
-S&P 500 -Value Line Index
-Vanguard Index
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Futures Contract Concepts

Not an actual sale
Always a winner & a loser (unlike stocks)
K are “settled” every day. (Marked to Market)
Hedge - K used to eliminate risk by locking in prices
Speculation - K used to gamble
Margin - not a sale - post partial amount

Hog K = 30,000 lbs

Tbill K = $1.0 mil
Value line Index K = $index x 500

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27- 14

SWAPS
birth 1981

Definition - An agreement between two firms, in which each

firm agrees to exchange the “interest rate characteristics” of
two different financial instruments of identical principal

Key points
Spread inefficiencies
Same notation principal
Only interest exchanged

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SWAPS
 “Plain Vanilla Swap” - (generic swap)
 fixed rate payer
 floating rate payer
 counterparties
 settlement date
 trade date
 effective date
 terms

 Swap Gain = fixed spread - floating spread

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SWAPS
example (vanilla/annually settled)
XYZ ABC
fixed rate 10% 11.5%
floating rate libor + .25 libor + .50

Q: if libor = 7%, what swap can be made 7 what is the profit (assume $1mil
face value loans)

A:
XYZ borrows $1mil @ 10% fixed
ABC borrows $1mil @ 7.5% floating
XYZ pays floating @ 7.25%
ABC pays fixed @ 10.50%

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SWAPS
example - cont
Benefit to XYZ Net position
floating +7.25 -7.25 0
fixed +10.50 -10.00 +.50
Net gain +.50%

Benefit ABC Net Position

floating +7.25 - 7.50 -.25
fixed -10.50 + 11.50 +1.00
net gain +.75%

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SWAPS
example - cont
Settlement date
ABC pmt 10.50 x 1mil = 105,000
XYZ pmt 7.25 x 1mil = 72,500
net cash pmt by ABC = 32,500

if libor rises to 9%
settlement date
ABC pmt 10.50 x 1mil = 105,000
XYZ pmt 9.25 x 1mil = 92,500
net cash pmt by ABC = 12,500

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SWAPS
 transactions
 rarely done direct
 banks = middleman
 bank profit = part of “swap gain”

example - same continued

XYZ & ABC go to bank separately
XYZ term = SWAP floating @ libor + .25 for fixed @ 10.50
ABC terms = swap floating libor + .25 for fixed 10.75

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SWAPS
example - cont
settlement date - XYZ
Bank pmt 10.50 x 1mil = 105,000
XYZ pmt 7.25 x 1mil = 72,500
net Bank pmt to XYZ = 32,500

settlement date - ABC

Bank pmt 7.25 x 1mil = 72,500
ABC pmt 10.75 x 1mil = 107,500
net ABC pmt to bank = 35,000

bank “swap gain” = +35,000 - 32,500 = +2,500

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SWAPS
example - cont
benefit to XYZ
floating 7.25 - 7.25 = 0
fixed 10.50 - 10.00 = +.50 net gain .50

benefit to ABC
floating 7.25 - 7.50 = - .25
fixed -10.75 + 11.50 = + .75 net gain .50

benefit to bank
floating +7.25 - 7.25 = 0
fixed 10.75 - 10.50 = +.25 net gain +.25

total benefit = 12,500 (same as w/o bank)

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Ex - Settlement & Speculate

Example - You are speculating in Hog Futures. You think that the
Spot Price of hogs will rise in the future. Thus, you go Long on
10 Hog Futures. If the price drops .17 cents per pound ($.0017)
what is total change in your position?

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Ex - Settlement & Speculate

Example - You are speculating in Hog Futures. You think that the
Spot Price of hogs will rise in the future. Thus, you go Long on
10 Hog Futures. If the price drops .17 cents per pound ($.0017)
what is total change in your position?

30,000 lbs x $.0017 loss x 10 Ks = $510.00 loss

50.63
cents
50.80 per lbs
-$510

Since you must settle your account every day, you must give
your broker $510.00

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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000
bushels of corn during the month of August. In June,
the September corn futures are selling for $2.94 per
bushel (1K = 5,000 bushels). Farmer Smith wishes
to lock in this price.
Show the transactions if the Sept spot price drops to
$2.80.

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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of
corn during the month of August. In June, the September corn
futures are selling for $2.94 per bushel (1K = 5,000 bushels).
Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price drops to $2.80.

Revenue from Crop: 10,000 x 2.80 28,000

June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 2.80 =
28,000 .
Gain on Position------------------------------- 1,400
Total Revenue $ 29,400
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Commodity Hedge
In June, farmer John Smith expects to harvest 10,000
bushels of corn during the month of August. In June,
the September corn futures are selling for $2.94 per
bushel (1K = 5,000 bushels). Farmer Smith wishes
to lock in this price.
Show the transactions if the Sept spot price rises to
$3.05.

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27- 27

Commodity Hedge
In June, farmer John Smith expects to harvest 10,000 bushels of
corn during the month of August. In June, the September corn
futures are selling for $2.94 per bushel (1K = 5,000 bushels).
Farmer Smith wishes to lock in this price.
Show the transactions if the Sept spot price rises to $3.05.

Revenue from Crop: 10,000 x 3.05 30,500

June: Short 2K @ 2.94 = 29,400
Sept: Long 2K @ 3.05 =
30,500 .
Loss on Position------------------------------- ( 1,100 )
Total Revenue $ 29,400
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Commodity Speculation
You have lived in NYC your whole life and are
independently wealthy. You think you know
everything there is to know about pork bellies
(uncurred bacon) because your butler fixes it for you
every morning. Because you have decided to go on a
diet, you think the price will drop over the next few
months. On the CME, each PB K is 38,000 lbs. Today,
you decide to short three May Ks @ 44.00 cents per
lbs. In Feb, the price rises to 48.5 cents and you
decide to close your position. What is your gain/loss?

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Commodity Speculation
You have lived in NYC your whole life and are
independently wealthy. You think you know
everything there is to know about pork bellies
(uncurred bacon) because your butler fixes it for you
every morning. Because you have decided to go on a
diet, you think the price will drop over the next few
months. On the CME, each PB K is 38,000 lbs. Today,
you decide to short three May Ks @ 44.00 cents per
lbs. In Feb, the price rises to 48.5 cents and you
decide to close your position. What is your gain/loss?

Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160

Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290
Loss of 10.23 % = - 5,130
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27- 30

Margin

 The amount (percentage) of a Futures

Contract Value that must be on deposit with a
broker.
 Since a Futures Contract is not an actual sale,
you need only pay a fraction of the asset
value to open a position = margin.
 CME margin requirements are 15%
 Thus, you can control $100,000 of assets with
only $15,000.
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27- 31

Commodity Speculation with margin

You have lived in NYC your whole life and are independently wealthy.
You think you know everything there is to know about pork bellies
(uncurred bacon) because your butler fixes it for you every morning.
Because you have decided to go on a diet, you think the price will drop
over the next few months. On the CME, each PB K is 38,000 lbs.
Today, you decide to short three May Ks @ 44.00 cents per lbs. In
Feb, the price rises to 48.5 cents and you decide to close your position.
What is your gain/loss?

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Commodity Speculation with margin

You have lived in NYC your whole life and are independently wealthy.
You think you know everything there is to know about pork bellies
(uncurred bacon) because your butler fixes it for you every morning.
Because you have decided to go on a diet, you think the price will drop
over the next few months. On the CME, each PB K is 38,000 lbs.
Today, you decide to short three May Ks @ 44.00 cents per lbs. In
Feb, the price rises to 48.5 cents and you decide to close your position.
What is your gain/loss?

Nov: Short 3 May K (.4400 x 38,000 x 3 ) = + 50,160

Feb: Long 3 May K (.4850 x 38,000 x 3 ) = - 55,290
Loss = - 5,130
Loss 5130 5130
------------ = -------------------- = ------------ = 68% loss
Margin 50160 x.15 7524
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