Hedging with Financial Derivatives

Financial derivatives enable financial institutions to hedge or engage in financial transactions which reduce or eliminate risk. When a financial institution has bought an asset, it is said to have taken a long position, and this exposes the institution to risk if the returns on the asset are uncertain. On the other hand, if it has sold an asset that it has agreed to deliver to another party at a future date, it is said to have taken a short position, and this can also expose the institution to risk. Financial derivatives can be used to reduce risk by invoking the following basic principle of hedging: Hedging risk involves engaging in a financial transaction that offsets a long position by taking an additional short position, or offsets a short position by taking an additional long position. We first look at how this principle is applied using forward contracts.

Forward contracts are agreements by two parties to engage in a financial transaction at a future (forward) point in time. Here we focus on forward contracts that are linked to debt instruments, called interest-rate forward contracts. An example of it might be an agreement for the First National Bank to sell to the Rock Solid Insurance Company, one year from today, $5 million face value of Treasury bonds at a price that yields the same interest rate on these bonds as today’s, say 6%. Rock Solid has taken a long position, while the First National has taken a short position. The previously bought $5 million of Treasury bonds are long-term bonds and the First National is exposed to interest-rate risk. How to hedge this risk? Following the basic principle of hedging, the First National wants to offset its long position in bonds by an equal short position for the same bonds with a forward contract, that is to sell these bonds at a future date at a current par value price. By entering into this forward contract with Rock Solid, the First National has locked in the future price and eliminated the price risk from interest-rate changes.

Why would the Rock Solid Insurance Company want to enter into the forward contract with the First National Bank? It expects to receive premiums of $5 million in one year’s time that it will want to invest in the Treasury bonds but worries that interest rates on these bonds will decline between now and next year. By using this forward contract, it is able to lock in the 6% interest rate on the Treasury bonds which will be sold to it by the First National Bank.

The advantage of forward contracts is that they can be as flexible as the parties involved want them to be. However, forward contracts suffer from two problems. The first is that it may be very hard for an institution to find a counterparty to make the contract with. The second problem is that forward contracts are subject to default risk because there is no outside organization guaranteeing the contract. Given the default risk and liquidity problems in the interest-rate forward market, another solution to hedging interest-rate risk was needed. This solution was provided by the development of financial futures contracts by the Chicago Board of Trade starting in 1975.

A financial futures contract is similar to an interest-rate forward contract in that it specifies that a financial instrument must be delivered by one party to another on a stated future date. However, it differs from an interest-rate forward contract in several ways that overcome some of the liquidity and default problems of forward markets.

The First National Bank can also use financial futures to hedge against the interest-rate risk on its holdings of $5 million of Treasury bonds. The basic principle of hedging indicates that it needs to offset the long position in these bonds with a short position, so the bank has to sell 50 $100,000 futures contracts to remove its interest-rate exposure from its $5 million of Treasury bonds. Financial futures contracts are traded in the United States on organized exchanges such as the Chicago Board of Trade, the Chicago Mercantile Exchange, the New York Futures Exchange, etc. These exchanges are highly competitive with one another and are regulated by government authorities. In contrast to forward contracts, the quantities delivered and the delivery dates of futures contracts are standardized, making it more likely that different parties can be matched up in the futures market, thereby increasing the liquidity of the market. Trading in the futures market has been organized to overcome the default risk problems arising in forward contracts: buyers and sellers contract not with each other but with the clearinghouse associated with the futures exchange. To make sure that the clearinghouse is financially sound and does not run into difficulties, buyers and sellers of futures contracts must put in an initial deposit, called a margin requirement, of perhaps $2,000 per Treasury bond contract into a margin account kept at their brokerage firm.

Financial institution managers, particularly those of mutual funds, pension funds, and insurance companies, also worry about stock market risk because stock prices fluctuate. Stock index futures were developed in 1982 to meet the need to manage stock market risk. Let’s look at the Standard &Poor’s 500 Index futures contract, the most widely traded stock index futures contract in the United States. Such contracts differ from most other financial futures contracts in that they are settled with a cash delivery rather than with the delivery of a security. Cash settlement makes these contracts highly liquid.

Suppose that in March 2010 the Rock Solid Insurance Company has a portfolio of stocks valued at $100 million that moves with the S&P Index. Suppose that the March 2011 S&P 500 Index futures contracts are currently selling at a price of 1,000 (that is $250,000). How many of these contracts should Rock Solid sell so that it hedges the stock market risk of this portfolio over the next year? The company must offset the risk by taking a short position on which it sells 400 $250,000 contracts.

Another vehicle for hedging interest-rate and stock market risk involves the use of options on financial instruments. Options are contracts that give the purchaser the option, or right, to buy or sell the underlying financial instrument at a specified price, called the exercise price or strike price, within a specific period of time. The seller (the writer) of the option is obligated to buy or sell the financial instrument to the purchaser if the owner of the option exercises the right to sell or buy. The owner or buyer of an option does not have to exercise the option; he or she can let the option expire without using it. The owner of an option is not obligated to take any action but rather has the right to exercise the contract if he or she chooses. The seller of an option, by contrast, has no choice in the matter: he or she must buy or sell the financial instrument if the owner exercises the option. Because the right to buy or sell has value, the owner of an option pays an amount for it called a premium. American options can be exercised at any time to the expiration date of the contract, and European options can be exercised only on the expiration date. Option contracts are written on a number of financial instruments. Options on individual stocks are called stock options. Option contracts on financial futures called financial futures options, or, more commonly, futures options, were developed in 1982 and have become the most widely traded option contracts. The regulation of option markets is split between the Securities and Exchange Commission (SEC), which regulates stock options, and the Commodity Futures Trading Commission (САЕС), which regulates futures options. Regulation focuses on ensuring that writers of options have enough capital to make good on their contractual obligations and on overseeing traders and exchanges to prevent fraud and ensure that the market is not being manipulated. The factors that determine the premium on an option contract are:

1. The higher the strike price, everything else being equal, the lower the premium on CALL (buy) options and the higher the premium on PUT (sell) options.

2. The greater the term of expiration, everything else being equal, the higher the premiums for both CALL and PUT options.

3. The greater the volatility of prices of the underlying financial instrument, everything else being equal, the higher the premiums for both CALL and PUT options.

In addition to forwards, futures, and options, financial institutions use one other important financial derivative to manage risk. Swaps are financial contracts that obligate each party to the contract to exchange (swap) a set of payments it owns for another set of payments owned by another party. There are two basic types of swaps: currency swaps involve the exchange of a set of payments in one currency for a set of payments in another currency. Interest-rate swaps involve the exchange of one set of (fixed rate) interest payments for another set of (variable rate) interest payments, all denominated in the same currency. The latter appeared in the United States in 1982 when there was an increase in the demand for financial instruments that could be used to reduce interest-rate risk.