Brealey−Meyers: Principles of Corporate Finance, 7th Edition - Chapter 27 docx

Key to abbreviations: CBT Chicago Board of Trade LME London Metal Exchange CME Chicago Mercantile Exchange MCE MidAmerica Commodity Exchange COMEX Commodity Exchange Division of NYMEX MP

M A N A G I N G R I S K

MOST OF THEtime we take risk as God-given An asset or business has its beta, and that’s that Itscash flow is exposed to unpredictable changes in raw material costs, tax rates, technology, and a longlist of other variables There’s nothing the manager can do about it.

That’s not wholly true To some extent managers can choose the risks that the business takes Wehave already come across one way that they can do so In our discussion of real options in Chapter 22

we described how companies reduce risk by building flexibility into their operations A company thatuses standardized machine tools rather than specialized equipment lowers the cost of bailing out ifthings go wrong A petrochemical plant that is designed to use either oil or natural gas as a feedstockreduces the impact of an unfavorable shift in relative fuel prices And so on

In this chapter we shall explain how companies also enter into financial contracts that insure against or

hedge (i.e., offset) a variety of business hazards But first we should give some reasons why they do so.

Insurance and hedging are seldom free: At best they are zero-NPV transactions.1Most businessesinsure or hedge to reduce risk, not to make money Why, then, bother to reduce risk in this way? Forone thing, it makes financial planning easier and reduces the odds of an embarrassing cash shortfall Ashortfall might mean only an unexpected trip to the bank, but if financing is hard to obtain on short no-tice, the company might need to cut back its capital expenditure program In extreme cases an un-hedged setback could trigger financial distress or even bankruptcy Banks and bondholders are aware

of this possibility, and, before lending to your firm, they will often insist that it is properly insured

In some cases hedging also makes it easier to decide whether an operating manager deserves astern lecture or a pat on the back Suppose your confectionery division shows a 60 percent profit in-crease in a period when cocoa prices decline by 12 percent How much of the increase is due to thechange in cocoa prices and how much to good management? If cocoa prices were hedged, it’s prob-ably good management If they were not, things have to be sorted out with hindsight by asking, What

would profits have been if cocoa prices had been hedged?2

Finally, hedging extraneous events can help focus the operating manager’s attention It’s naive to

expect the manager of the confectionery division not to worry about cocoa prices if her bottom line

and bonus depend on them That worrying time would be better spent if the prices were hedged.3

Of course, managers are not paid to avoid all risks, but if they can reduce their exposure to risksfor which there are no compensating rewards, they can afford to place larger bets when the odds are

in their favor

755

1

Hedging transactions are zero-NPV when trading is costless and markets are completely efficient In

practice the firm has to pay small trading costs at least.

2

Many large firms insure or hedge away operating divisions’ risk exposures by setting up internal,

make-believe markets between each division and the treasurer’s office Trades in the internal markets are at real

(external) market prices The object is to relieve the operating managers of risks outside their control The

treasurer makes a separate decision on whether to offset the firm’s exposure.

3

A Texas oilman who lost hundreds of millions in ill-fated deals protested, “Why should I worry? Worry

is for strong minds and weak characters.” If there are any financial managers with weak minds and

strong characters, we especially advise them to hedge whenever they can.

27.1 INSURANCE

Most businesses buy insurance against a variety of hazards—the risk that their plant

will be damaged by fire; that their ships, planes, or vehicles will be involved in

acci-dents; that the firm will be held liable for environmental damage; and so on

When a firm takes out insurance, it is simply transferring the risk to the ance company Insurance companies have some advantages in bearing risk First,they may have considerable experience in insuring similar risks, so they are wellplaced to estimate the probability of loss and price the risk accurately Second, theymay be skilled at providing advice on measures that the firm can take to reduce therisk, and they may offer lower premiums to firms that take this advice Third, an

insur-insurance company can pool risks by holding a large, diversified portfolio of

poli-cies The claims on any individual policy can be highly uncertain, yet the claims on

a portfolio of policies may be very stable Of course, insurance companies cannotdiversify away macroeconomic risks; firms use insurance policies to reduce theirspecific risk, and they find other ways to avoid macro risks

Insurance companies also suffer some disadvantages in bearing risk, and these

are reflected in the prices they charge Suppose your firm owns a $1 billion offshoreoil platform A meteorologist has advised you that there is a 1-in-10,000 chance that

in any year the platform will be destroyed as a result of a storm Thus the expected

The risk of storm damage is almost certainly not a macroeconomic risk and canpotentially be diversified away So you might expect that an insurance companywould be prepared to insure the platform against such destruction as long as thepremium was sufficient to cover the expected loss In other words, a fair premium

insurance a zero-NPV deal for your company Unfortunately, no insurance pany would offer a policy for only $100,000 Why not?

com-• Reason 1: Administrative costs An insurance company, like any other business,

incurs a variety of costs in arranging the insurance and handling any claims.For example, disputes about the liability for environmental damage can eat upmillions of dollars in legal fees Insurance companies need to recognize thesecosts when they set their premiums

• Reason 2: Adverse selection Suppose that an insurer offers life insurance policies

with “no medical needed, no questions asked.” There are no prizes forguessing who will be most tempted to buy this insurance Our example is an

extreme case of the problem of adverse selection Unless the insurance company

can distinguish between good and bad risks, the latter will always be mosteager to take out insurance Insurers increase premiums to compensate

• Reason 3: Moral hazard Two farmers met on the road to town “George,” said

one, “I was sorry to hear about your barn burning down.” “Shh,” replied theother, “that’s tomorrow night.” The story is an example of another problem for

insurers, known as moral hazard Once a risk has been insured, the owner may

be less careful to take proper precautions against damage Insurancecompanies are aware of this and factor it into their pricing

When these extra costs are small, insurance may be close to a zero-NPV tion When they are large, insurance may be a costly way to protect against risk

transac-Many insurance risks are jump risks; one day there is not a cloud on the

hori-zon and the next day the hurricane hits The risks can also be huge For example,Hurricane Andrew, which devastated Florida, cost insurance companies $17 bil-

until the end, then the zero-NPV premium equals the discounted value of the expected claim or

lion; the attack on the World Trade Center is likely to involve payments of more

than $35 billion

Many in the industry worry that one day a major disaster will wipe out a large

proportion of the capital of the U.S insurance industry Therefore, insurance

com-panies have been looking for ways to share these risks with investors One solution

is for the insurance company to issue catastrophe bonds (or Cat bonds) The payment

The first public issue of a Cat bond was made by the Swiss insurance giant,

Win-terthur As a major provider of automobile insurance, Winterthur wanted to

pro-tect itself against the risk that storm damage could lead to an unusually large

num-ber of claims Therefore, when it issued its bond, the company stated that it would

not pay the annual interest if ever there was a hailstorm in Switzerland which

dam-aged at least 6,000 cars that it had insured In effect, owners of the Winterthur Cat

bonds coinsured the company’s risks

Major public companies typically buy insurance against large potential losses and

self-insure against routine ones The idea is that large losses can trigger financial

distress On the other hand, routine losses for a corporation are predictable, so

there is little point paying premiums to an insurance company and receiving back

a fairly constant proportion as claims

BP Amoco has challenged this conventional wisdom Like all oil companies, BP

is exposed to a variety of potential losses Some arise from routine events such as

vehicle accidents and industrial injuries At the other extreme, they may result

from catastrophes such as a major oil spill or the loss of an offshore oil rig In the

an average of $115 million a year in insurance premiums and recovered $25 million

a year in claims

BP then took a hard look at its insurance strategy It decided to allow local

man-agers to insure against routine risks, for in those cases insurance companies have

an advantage in assessing and pricing risk and compete vigorously against one

an-other However, it decided not to insure against most losses above $10 million For

these larger, more specialized risks BP felt that insurance companies had less

abil-ity to assess risk and were less well placed to advise on safety measures As a

re-sult, BP concluded, insurance against large risks was not competitively priced

How much extra risk did BP assume by its decision not to insure against major

losses? BP estimated that large losses of above $500 million could be expected to

occur once in 30 years But BP is a huge company with equity worth about $180

bil-lion So even a $500 million loss, which could throw most companies into

bank-ruptcy, would translate after tax into a fall of less than 1 percent in the value of

“Fi-nancial Innovation in the Management of Catastrophe Risk,” Journal of Applied Corporate Finance 10 (Fall

1997), pp 84–95; and K Froot, “The Market for Catastrophe Risk: A Clinical Examination,” Journal of

Fi-nancial Economics 60 (2001), pp 529–571.

“Cor-porate Insurance Strategy: The Case of British Petroleum,” Journal of Applied Cor“Cor-porate Finance 6 (Fall

1993), pp 4–15.

$500 million or more.

BP’s equity BP concluded that this was a risk worth taking In other words, it cluded that for large, low-probability risks the stock market was a more efficientrisk-absorber than the insurance industry.

con-BP Amoco is not the only company that has looked at the package of risks that

it faces and the way that these risks should be managed Here is how The Economist

Duke’s risk managers are currently designing a model that examines different types

of risk together: movements in exchange rates, changes in raw material prices, downtime caused by distribution failures, and so on This is supposed to produce

an “aggregate loss distribution,” which estimates the likelihood that several events could happen at once and sink the company With this better understanding of the company’s aggregate risk, Duke’s managers can make a more informed decision about how much of this potential loss should be absorbed by shareholders, how much hedged in the financial markets, and how much transferred to insurers.

of whom may be wicked, but they are also used by sober and prudent businesspeople to reduce risk.

postharvest wheat price In this case the miller is in the hazardous position of having fixed her cost but not her selling price This point is discussed in A C Shapiro and S Titman, “An Integrated Approach

to Corporate Risk Management,” Midland Corporate Finance Journal 3 (Summer 1985), pp 41–56.

27.2 HEDGING WITH FUTURES

Hedging involves taking on one risk to offset another We will explain shortly how

to set up a hedge, but first we will give some examples and describe some tools thatare specially designed for hedging These are futures, forwards, and swaps To-

gether with options, they are known as derivative instruments or derivatives because

their value depends on the value of another asset You can think of them as side

We start with the oldest actively traded derivative instruments, futures

con-tracts.Futures were originally developed for agricultural and other commodities.For example, suppose that a wheat farmer expects to have 100,000 bushels of wheat

to sell next September If he is worried that the price may decline in the interim, hecan hedge by selling 100,000 bushels of September wheat futures In this case heagrees to deliver 100,000 bushels of wheat in September at a price that is set today

Do not confuse this futures contract with an option, in which the holder has achoice whether to make delivery; the farmer’s futures contract is a firm promise todeliver wheat

A miller is in the opposite position She needs to buy wheat after the harvest If she would like to fix the price of this wheat ahead of time, she can do so by buying

wheat futures In other words, she agrees to take delivery of wheat in the future at

a price that is fixed today The miller also does not have an option; if she holds thecontract to maturity, she is obliged to take delivery

hedged risk by selling wheat futures; this is termed a short hedge The miller has hedged risk by buying wheat futures; this is known as a long hedge.

The price of wheat for immediate delivery is known as the spot price When the

farmer sells wheat futures, the price that he agrees to take for his wheat may be

very different from the spot price But as the date for delivery approaches, a futures

contract becomes more and more like a spot contract and the price of the future

snuggles up to the spot price

The farmer may decide to wait until his futures contract matures and then

de-liver wheat to the buyer In practice such dede-livery is very rare, for it is more

properly hedged, any loss on his wheat crop will be exactly offset by the profit on

his sale and subsequent repurchase of wheat futures

Commodity and Financial Futures

Futures contracts are bought and sold on organized futures exchanges Table 27.1

lists the principal commodity futures contracts and the exchanges on which they are

traded Notice that our farmer and miller are not the only businesses that can hedge

T A B L E 2 7 1

Some commodity futures and the principal exchanges on which they are traded.

Key to abbreviations:

CBT Chicago Board of Trade LME London Metal Exchange

CME Chicago Mercantile Exchange MCE MidAmerica Commodity Exchange

COMEX Commodity Exchange Division of NYMEX MPLS Minneapolis Grain Exchange

IPE International Petroleum Exchange of London NYBOT New York Board of Trade

KC Kansas City Board of Trade NYMEX New York Mercantile Exchange

LIFFE London International Financial WPG Winnipeg Commodity Exchange

Futures and Options Exchange

the buyer simply receives (or pays) the difference between the spot price and the price at which he or

she agreed to purchase the asset.

risk with commodity futures The lumber company and the builder can hedgeagainst changes in lumber prices, the copper producer and the cable manufacturercan hedge against changes in copper prices, the oil producer and the trucker can

For many firms the wide fluctuations in interest rates and exchange rateshave become at least as important a source of risk as changes in commodityprices Financial futures are similar to commodity futures, but instead of plac-ing an order to buy or sell a commodity at a future date, you place an order tobuy or sell a financial asset at a future date Table 27.2 lists some important fi-nancial futures It is far from complete You can trade futures on the Thailandstock market index, the South African rand, Finnish government bonds, andmany other financial assets

Financial futures have been a remarkably successful innovation They were vented in 1972; within a few years, trading in financial futures significantly ex-ceeded trading in commodity futures

Unsuccess-ful contracts are regularly dropped, and at any time the exchanges may be seeking approval for ally dozens of new contracts.

T A B L E 2 7 2

Some financial futures and the principal exchanges on which they are traded.

Key to abbreviations:

CBT Chicago Board of Trade

CME Chicago Mercantile Exchange

LIFFE London International Financial Futures and Options Exchange

MATIF Marché à Terme d’Instruments Financiers

OSE Osaka Securities Exchange

SIMEX Singapore International Monetary Exchange

TIFFE Tokyo International Financial Futures Exchange

TSE Tokyo Stock Exchange

The Mechanics of Futures Trading

When you buy or sell a futures contract, the price is fixed today but payment is not

made until later You will, however, be asked to put up margin in the form of either

cash or Treasury bills to demonstrate that you have the money to honor your side

of the bargain As long as you earn interest on the margined securities, there is no

cost to you

In addition, futures contracts are marked to market This means that each day any

profits or losses on the contract are calculated; you pay the exchange any losses

and receive any profits For example, suppose that our farmer agreed to deliver

100,000 bushels of wheat at $2.80 a bushel The next day the price of wheat futures

declines to $2.75 a bushel The farmer now has a profit on his sale of

The exchange’s clearinghouse therefore pays this $5,000 to the farmer

You can think of the farmer as closing out his position every day and then opening up

a new position Thus after the first day the farmer has realized a profit of $5,000 on his

trade and now has an obligation to deliver wheat for $2.75 a bushel The $.05 that the

farmer has already been paid plus the $2.75 that remains to be paid equals the $2.80

selling price at which the farmer originally agreed to deliver wheat

Of course, our miller is in the opposite position The fall in the futures price

leaves her with a loss of $.05 a bushel She must, therefore, pay over this loss to the

exchange’s clearinghouse In effect the miller closes out her initial purchase at a

Spot and Futures Prices—Financial Futures

If you want to buy a security, you have a choice You can buy it for immediate

de-livery at the spot price Alternatively, you can place an order for later dede-livery; in

this case you buy at the futures price When you buy a financial future, you end up

with exactly the same security that you would have if you bought in the spot

mar-ket However, there are two differences First, you don’t pay for the security up

front, and so you can earn interest on its purchase price Second, you miss out on

any dividend or interest that is paid in the interim This tells us something about

this formula works

Example: Stock Index Futures Suppose six-month stock index futures trade at

1,205 when the index is 1,190 The six-month interest rate is 4 percent, and the

av-erage dividend yield of stocks in the index is 1.6 percent per year Are these

honor his or her side of the bargain The futures exchange guarantees the contract and protects itself by

settling up profits and losses each day.

the future depends on the path of interest rates up to the delivery date In practice this qualification is

usually unimportant See J C Cox, J E Ingersoll, and S A Ross, “The Relationship between Forward

and Futures Prices,” Journal of Financial Economics 9 (1981), pp 321–346.

Suppose you buy the futures contract and set aside the money to exercise it At

a 4 percent annual rate, you’ll earn about 2 percent interest over the next sixmonths Thus you invest

What do you get in return? Everything you would have gotten by buying the dex now at the spot price, except for the dividends paid over the next six months

in-If we assume, for simplicity, that a half-year’s dividends are paid in month six(rather than evenly over six months), your payoff is

You get what you pay for

Spot and Futures Prices—Commodities

The difference between buying commodities today and buying commodity futures is

more complicated First, because payment is again delayed, the buyer of the futureearns interest on her money Second, she does not need to store the commodities and,therefore, saves warehouse costs, wastage, and so on On the other hand, the futures

contract gives no convenience yield, which is the value of being able to get your hands

on the real thing The manager of a supermarket can’t burn heating oil futures ifthere’s a sudden cold snap, and he can’t stock the shelves with orange juice futures if

No one would be willing to hold the futures contract at a higher futures price or to

It’s interesting to compare the formulas for futures prices of commodities to theformulas for securities PV(convenience yield) plays the same role as PV(dividends

or interest payments forgone) But financial assets cost nothing to store, so age costs) does not appear in the formula for financial futures

PV(stor-You can’t observe PV(convenience yield) or PV(storage) separately, but you caninfer the difference between them by comparing the spot price to the discountedfutures price This difference—that is, convenience yield less storage cost—is

called net convenience yield.

Here is an example using quotes for August 2001 At that time the spot price

of coffee was about 51 cents per pound The futures price for March 2002 was 58.7 cents Of course, if you bought and held the futures, you would not pay untilMarch The present value of this outlay is 57.4 cents, using a one-year interest rate

of 4 percent So PV(net convenience yield) is negative at 6.4 cents a pound:

51  57.4
6.4 cents

f

Futures price

Futures price

15 Our formula could overstate the futures price if no one is willing to hold the commodity, that is, if in- ventories fall to zero or some absolute minimum.

Sometimes the net convenience yield is expressed as a percentage of the spot

ample supply and evidently roasters had no worries that they would run short

in the months ahead

Figure 27.1 plots percentage net convenience yields for crude oil and gas oil

(used for heating) Notice how much the spread between the spot and futures

price for gas oil bounces around When there are shortages or fears of an

inter-ruption of supply, traders may be prepared to pay 2 or more percent per week

for the convenience of having oil in the tanks rather than the promise of future

There is one further complication that we should note There are some

com-modities that cannot be stored at all You can’t store electricity, for example As a

result, electricity supplied in, say, six-months’ time is effectively a different

com-modity from electricity available now, and there is no simple link between today’s

price and that of a futures contract to buy or sell at the end of six months Of course,

12.5

6.4/51
.125

16

For evidence that the net convenience yield is related to the level of inventories, see M J Brennan, “The

Price of Convenience and the Valuation of Commodity Contingent Claims,” in D Lund and B Øksendal

(eds.), Stochastic Models and Option Values, North-Holland Publishing Company, Amsterdam, 1991.

Weekly percentage net convenience yield (convenience yield less storage costs) for two commodities.

Source: R S Pindyck, “The Present Value Model of Rational Commodity Pricing,” Economic Journal 103 (May 1993),

pp 511–530 We thank Professor Pindyck for updating the data.

generators and consumers will have their own views of what the spot price is likely

to be when those six months have elapsed, and they may be more or less eager tofix today the price at which they buy or sell

27.3 FORWARD CONTRACTS

Each day billions of dollars of futures contracts are bought and sold This liquidity

is possible only because futures contracts are standardized and mature on a ited number of dates each year

lim-Fortunately there is usually more than one way to skin a financial cat If theterms of futures contracts do not suit your particular needs, you may be able to buy

or sell a forward contract Forward contracts are simply tailor-made futures

con-tracts The main forward market is in foreign currency We will discuss forward change rates in the next chapter

ex-It is also possible to enter into a forward interest rate contract For example,suppose that you know that at the end of six months you are going to need athree-month loan You worry that interest rates will rise over the six-month pe-

riod You can lock in the interest rate on that loan by buying a forward rate

agree-ment (FRA) from a bank.17 For example, the bank might offer to sell you a

of six months the three-month LIBOR rate is greater than 7 percent, the bank willpay you the difference; if three-month LIBOR is less than 7 percent, you pay the

Homemade Forward Contracts

Suppose that you borrow $90.91 for one year at 10 percent and lend $90.91 for twoyears at 12 percent These interest rates are for loans made today; therefore, theyare spot interest rates

The cash flows on your transactions are as follows:

would be said to “buy six against nine months” money, meaning that the forward rate agreement is for

a three-month loan in six months’ time.

Lon-don lend each other dollars.

when the contract matures.

Notice that you do not have any net cash outflow today but you have contracted

to pay out money in year 1 The interest rate on this forward commitment is14.04 percent To calculate this forward interest rate, we simply worked out theextra return for lending for two years rather than one:

In our example you manufactured a forward loan by borrowing short-term and

lending long But you can also run the process in reverse If you wish to fix today

the rate at which you borrow next year, you borrow long and lend the money

un-til you need it next year

Some company cash flows are fixed Others vary with the level of interest rates,

rates of exchange, prices of commodities, and so on These characteristics may not

always result in the desired risk profile For example, a company that pays a fixed

rate of interest on its debt might prefer to pay a floating rate, while another

com-pany that receives cash flows in euros might prefer to receive them in yen Swaps

allow them to change their risk in these ways

The market for swaps is huge In 2000 the total notional amount of swaps

out-standing was estimated at over $50 trillion The major part of this figure consisted

of interest rate swaps, but it is also possible to swap different currencies, equity

then describe a currency swap We conclude with a brief look at default swaps The

default swap is an example of a credit derivative, a relatively new box of tools for

managing risk

Interest Rate Swaps

Friendly Bancorp has made a five-year, $50 million loan to fund part of the

con-struction cost of a large cogeneration project The loan carries a fixed interest rate

of 8 percent Annual interest payments are therefore $4 million Interest payments

are made annually, and all the principal will be repaid at year 5

Suppose that instead of receiving fixed interest payments of $4 million a year, the

bank would prefer to receive floating-rate payments It can do so by swapping the

$4 million, five-year annuity (the fixed interest payments) into a five-year

floating-rate annuity We will show first how Friendly Bancorp can make its own homemade

swap Then we will describe a simpler procedure

mil-lion The bank can now construct the homemade swap as follows: It borrows $66.67

million at a fixed interest rate of 6 percent for five years and simultaneously lends

Equity swaps typically involve one party receiving the dividends and capital gains on an equity index,

while the other party receives a fixed or floating rate of interest Similarly, in a commodity swap one

party receives a payment linked to the commodity price and the other receives the interest rate.

profit on the project financing.

the same amount at LIBOR We assume that LIBOR is initially 5 percent.22LIBOR

is a short-term interest rate, so future interest receipts will fluctuate as the bank’sinvestment is rolled over

The net cash flows to this strategy are shown in the top portion of Table 27.3 tice that there is no net cash flow in year 0 and that in year 5 the principal amount

No-of the short-term investment is used to pay No-off the $66.67 million loan What’s left?

A cash flow equal to the difference between the interest earned

and the $4 million outlay on the fixed loan The bank also has $4 million per yearcoming in from the project financing, so it has transformed that fixed payment into

a floating payment keyed to LIBOR

Of course, there’s an easier way to do this, shown in the bottom portion of

Bancorp takes this easier route Let’s see what happens

Friendly Bancorp calls a swap dealer, which is typically a large commercial or

investment bank, and agrees to swap the payments on a $66.67 million fixed-rate

loan for the payments on an equivalent floating-rate loan The swap is known as a

fixed-to-floating interest rate swap and the $66.67 million is termed the notional

principal amount of the swap Friendly Bancorp and the dealer are the ties to the swap.

This figure is sometimes quoted as a spread over the yield on U.S Treasuries For

1LIBOR  66.672

22 Maybe the short-term interest rate is below the five-year interest rate because investors expect inter- est rates to rise.

23 Both strategies are equivalent to a series of forward contracts on LIBOR The forward prices are $4 mil-

be $4 million for any one year, but the PVs of the “annuities” of forward prices would be identical 24

Notice that the swap rate always refers to the interest rate on the fixed leg of the swap Rates are erally quoted against LIBOR, though dealers will also be prepared to quote rates against other short- term debt.

Standard fixed-to-floating swap:

T A B L E 2 7 3

The top panel shows the cash flows to a homemade fixed-to-floating interest rate swap The bottom panel shows the cash flows to a standard swap transaction.

example, if the yield on five-year Treasury notes is 5.25 percent, the swap spread is

The first payment on the swap occurs at the end of year 1 and is based on the

5 percent of $66.67 million, while the bank (which pays fixed) owes the dealer

$4 million (6 percent of $66.67 million) The bank therefore makes a net payment

Term Capital Management (LTCM) came close to collapse, five-year swap spreads nearly doubled

from 0.5 percent to 0.8 percent.

payments.

The second payment is based on LIBOR at year 1 Suppose it increases to 6 percent

Then the net payment is zero:

The third payment depends on LIBOR at year 2, and so on

Notice that, when the two counterparties entered into the swap, the deal was

fairly valued In other words, the net cash flows had zero present value What

hap-pens to the value of the swap as time passes? That depends on long-term interest

rates For example, suppose that after two years interest rates are unchanged, so a

6 percent note issued by the bank would continue to trade at its face value In this

case the swap still has zero value (You can confirm this by checking that the NPV

of a new three-year homemade swap is zero.) But if long rates increase over the two

years to 7 percent (say), the value of a three-year note falls to

Now the fixed payments that the bank has agreed to make are less valuable and

How do we know the swap is worth $1.75 million? Consider the following strategy:

1 The bank can enter a new three-year swap deal in which it agrees to pay

LIBOR on the same notional principal of $66.67 million

2 In return it receives fixed payments at the new 7 percent interest rate, that

The new swap cancels the cash flows of the old one, but it generates an extra

$.67 million for three years This extra cash flow is worth

Remember, ordinary interest rate swaps have no initial cost or value ),but their value drifts away from zero as time passes and long-term interest rateschange One counterparty wins as the other loses.

In our example, the swap dealer loses from the rise in interest rates Dealers willtry to hedge the risk of interest rate movements by engaging in a series of futures

or forward contracts or by entering into an offsetting swap with a third party Aslong as Friendly Bancorp and the other counterparty honor their promises, thedealer is fully protected against risk The recurring nightmare for swap managers

is that one party will default, leaving the dealer with a large unmatched position

This is called counterparty risk.

Currency Swaps

We now look briefly at an example of a currency swap

Suppose that the Possum Company needs 11 million euros to help finance its pean operations We assume that the euro interest rate is about 5 percent, whereas thedollar rate is about 6 percent Since Possum is better known in the United States, the fi-nancial manager decides not to borrow euros directly Instead, the company issues

Euro-$10 million of five-year 6 percent notes in the United States Then it arranges with acounterparty to swap this dollar loan into euros Under this arrangement the counter-party agrees to pay Possum sufficient dollars to service its dollar loan, and in exchangePossum agrees to make a series of annual payments in euros to the counterparty.Here are Possum’s cash flows (in millions):

1NPV
0

Look first at the cash flows in year 0 Possum receives $10 million from its issue ofdollar notes, which it then pays over to the swap counterparty In return the coun-

Now move to years 1 through 4 Possum needs to pay interest of 6 percent on its

agrees to provide Possum each year with sufficient cash to pay this interest and inreturn Possum makes an annual payment to the counterparty of 5 percent of a11 million, or a.55 million Finally, in year 5 the swap counterparty pays Possumenough to make the final payment of interest and principal on its dollar notes

The combined effect of Possum’s two steps (line 3) is to convert a 6 percent lar loan into a 5 percent euro loan You can think of the cash flows for the swap(line 2) as a series of contracts to buy euros in years 1 through 5 In each of years

dol-1 through 4 Possum agrees to purchase $.6 million at a cost of 5 million euros; in