Chapter 26: Derivatives and Hedging Risk

Questions and Problems:

26.1 The price quote is $4.8350 per bushel and each contract is for 5,000 bushels, so the initial contract value is:

Initial contract value = $4.8350 per bushel  5,000 bushels per contract = $24,175

At a final price of $4.95 per bushel, the value of the position is:

Final contract value = $4.95 per bushel  5,000 bushels per contract = $24,750

Since this is a long position, there is a net gain of:

$24,750 – $24,175 = $575

26.2 The price quote is $4.49 per bushel and each contract is for 5,000 bushels, so the initial contract value is:

Initial contract value = $4.49 per bushel  5,000 bushels per contract = $22,450

At a final price of $4.38 per bushel, the value of the position is:

Final contract value = $4.38 per bushel  5,000 bushels per contract = $21,900

Since this is a short position, there is a net gain of:

$22,450 – $21,900 = $550 per contract

Since you sold five contracts, the net gain is:

Net loss = 5 x $550 = $2,750

At a final price of $4.71 per bushel, the value of the position is:

Final contract value = $4.71 per bushel  5,000 bushels per contract = $23,550

Since this is a short position, there is a net loss of

$23,550 – $22,450 = $1,100

Since you sold five contracts, the net loss is:

Net loss = 5 x $1,100 = $5,500

With a short position, you make a profit when the price falls, and incur a loss when the price rises.

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26.3 The call options give the manager the right to purchase oil futures contracts at a futures price of $95 per barrel.
The manager will exercise the option if the price rises above $95. Selling put options obligates the manager to buy
oil futures contracts at a futures price of $95 per barrel. The put holder will exercise the option if the price falls
below $95. The payoffs per barrel are:

Oil futures price $90 $92 $95 $98 $100

Value of call option position: 0 0 0 3 5
Value of put option position: –5 –3 0 0 0
Total value: –$5 –$3 $0 $3 $5
The payoff profile is identical to that of a forward contract with a $95 forward price.

26.4 When you purchase the contracts, the initial value is:

Initial value = 10  100  $951

Initial value = $951,000

At the end of the first day, the value of your account is:

Day 1 account value = 10  100  $943

Day 1 account value = $943,000

So, your cash flow is:

Day 1 cash flow = $943,000 – $951,000

Day 1 cash flow = –$8,000

The day 2 account value is:

Day 2 account value = 10  100  $946

Day 2 account value = $946,000

So, your cash flow is:

Day 2 cash flow = $946,000 – $943,000

Day 2 cash flow = $3,000

The day 3 account value is:

Day 3 account value = 10  100  $953

Day 3 account value = $953,000

So, your cash flow is:

Day 3 cash flow = $953,000 – $946,000

Day 3 cash flow = $7,000

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 The day 4 account value is:

Day 4 account value = 10  100  $957

Day 4 account value = $957,000

So, your cash flow is:

Day 4 cash flow = $957,000 – $953,000

Day 4 cash flow = $4,000

Your total profit for the transaction is:

Profit = $957,000 – $951,000

Profit = $6,000

26.5 When you purchase the contracts, your cash outflow is:

Cash outflow = 25  42,000  $1.41

Cash outflow = $1,480,500

At the end of the first day, the value of your account is:

Day 1 account value = 25  42,000  $1.37

Day 1 account value = $1,438,500

Remember, on a short position you gain when the price declines, and lose when the price increases. So, your cash
flow is:

Day 1 cash flow = $1,480,500 – $1,438,500

Day 1 cash flow = $42,000

The day 2 account value is:

Day 2 account value = 25  42,000  $1.42

Day 2 account value = $1,491,000

So, your cash flow is:

Day 2 cash flow = $1,438,500 – $1,491,000

Day 2 cash flow = –$52,500

The day 3 account value is:

Day 3 account value = 25  42,000  $1.45

Day 3 account value = $1,522,500

So, your cash flow is:

Day 3 cash flow = $1,491,000 – $1,522,500

Day 3 cash flow = –$31,500

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 The day 4 account value is:

Day 4 account value = 25  42,000  $1.51

Day 4 account value = $1,585,500

So, your cash flow is:

Day 4 cash flow = $1,522,500 – $1,585,500

Day 4 cash flow = –$63,000

You total profit for the transaction is:

Profit = $1,480,500 – $1,585,500

Profit = –$105,000

26.6 The duration of a bond is the average time to payment of the bond’s cash flows, weighted by the ratio of the present
value of each payment to the price of the bond. Since the bond is selling at par, the market interest rate must equal
8 percent, the annual coupon rate on the bond. The price of a bond selling at par is equal to its face value. Therefore,
the price of this bond is $1,000. The relative value of each payment is the present value of the payment divided by
the price of the bond. The contribution of each payment to the duration of the bond is the relative value of the
payment multiplied by the amount of time (in years) until the payment occurs. So, the duration of the bond is:

Year PV of payment Relative value Payment × weight

1 $74.07 0.07407 0.07407
2 68.59 0.06859 0.13717
3 857.34 0.85734 2.57202
Price of bond = $1,000 Duration = 2.78326

26.7 The duration of a bond is the average time to payment of the bond’s cash flows, weighted by the ratio of the present
value of each payment to the price of the bond. Since the bond is selling at par, the market interest rate must equal
8 percent, the annual coupon rate on the bond. The price of a bond selling at par is equal to its face value. Therefore,
the price of this bond is $1,000. The relative value of each payment is the present value of the payment divided by
the price of the bond. The contribution of each payment to the duration of the bond is the relative value of the
payment multiplied by the amount of time (in years) until the payment occurs. So, the duration of the bond is:

Year PV of payment Relative value Payment × weight

1 $74.07 0.07407 0.07407
2 68.59 0.06859 0.13717
3 63.51 0.06351 0.19052
4 793.83 0.79383 3.17533
Price of bond = $1,000 Duration = 3.57710

26.8 The duration of a portfolio of assets or liabilities is the weighted average of the duration of the portfolio’s individual
items, weighted by their relative market values.

a. The total market value of assets in millions is:

Market value of assets = $31 + $590 + $340 + $98 + $485

Market value of assets = $1,544

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 So, the market value weight of each asset is:

Federal funds deposits = $31/$1,544 = 0.020

Accounts receivable = $590/$1,544 = 0.382
Short-term loans = $340/$1,544 = 0.220
Long-term loans = $98/$1,544 = 0.063
Mortgages = $485/$1,544 = 0.314

Since the duration of a group of assets is the weighted average of the durations of each individual asset in the
group, the duration of assets is:

Duration of assets = 0.020  0 + 0.382  0.20 + 0.220  0.65 + 0.063  5.25 + 0.314  12.85
Duration of assets = 4.59 years

b. The total market value of liabilities in millions is:

Market value of liabilities = $645 + $410 + $336

Market value of liabilities = $1,391

Note that equity is not included in this calculation since it is not a liability. So, the market value weight of each
asset is:

Checking and savings deposits = $645/$1,391 = 0.464

Certificates of deposit = $410/$1,391 = 0.295
Long-term financing = $336/$1,391 = 0.242

Since the duration of a group of liabilities is the weighted average of the durations of each individual asset in
the group, the duration of liabilities is:

Duration of liabilities = 0.464  0 + 0.295  1.60 + 0.242  9.80

Duration of liabilities = 2.84 years

c. The following relationship must hold for the bank to be immunized:

Duration of assets × Market value of assets = Duration of liabilities × Market value of liabilities

Duration of liabilities = Duration of assets × (Market value of assets/Market value of liabilities)

Duration of liabilities = 4.59 × ($1,544/$1,391) = 5.09 years

The current duration of liabilities (2.84 years) is less than the optimal duration of liabilities (5.09 years), so the
bank is not immune to interest rate risk. It is recommended that the bank increase the duration of its liabilities
while holding the duration of its assets constant, or decrease the duration of its assets while holding the duration
of its liabilities constant, in a way that makes the above relationship hold.

26.9 a. You’re concerned about a rise in wheat prices, so you would buy July contracts. Since each contract is for
5,000 bushels, the number of contracts you would need to buy is:

Number of contracts to buy = 140,000/5,000 = 28

By doing so, you’re effectively locking in the settle price in July, 2018 of $6.0175 per bushel of wheat, or:
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 Total price for 140,000 bushels = 28  $6.0175  5,000 = $842,450

b. If the price of wheat at expiration is $6.20 per bushel, the value of you futures position is:

Value of futures position = $6.20 per bu.  5,000 bu. per contract  28 contracts = $868,000

Ignoring any transaction costs, your gain on the futures position will be:

Gain = $868,000 – $842,450 = $25,550

While the price of the wheat your firm needs has become $25,550 more expensive since March, your profit
from the futures position has netted out this higher cost.

26.10 The duration of a liability is the average time to payment of the cash flows required to retire the liability, weighted
by the ratio of the present value of each payment to the present value of all payments related to the liability. In
order to determine the duration of a liability, first calculate the present value of all the payments required to retire
it. Since the cost is $30,000 at the beginning of each year for four years, we can find the present value of each
payment using the PV equation:

PV = FV/(1 + R)t

So, the PV each year of college is:

Year 1 PV = $30,000/1.097 = $16,411.03

Year 2 PV = $30,000/1.098 = $15,055.99
Year 3 PV = $30,000/1.099 = $13,812.83
Year 4 PV = $30,000/1.0910= $12,672.32

So, the total PV of the college cost is:

PV of college cost = $16,411.03 + $15,055.99 + $13,812.83 + $12,672.32

PV of college cost = $57,952.17

Now, we can set up the following table to calculate the liability’s duration. The relative value of each payment is
the present value of the payment divided by the present value of the entire liability. The contribution of each
payment to the duration of the entire liability is the relative value of the payment multiplied by the amount of time
(in years) until the payment occurs.

Year PV of payment Relative value Payment × weight

7 $16,411.03 0.28318 1.9823
8 15,055.99 0.25980 2.0784
9 13,812.83 0.23835 2.1451
10 12,672.32 0.21867 2.1867
PV of college cost = $57,952.17 Duration = 8.3925

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26.11 The duration of a bond is the average time to payment of the bond’s cash flows, weighted by the ratio of the present
value of each payment to the price of the bond. We need to find the present value of the bond’s payments at the
market rate. The relative value of each payment is the present value of the payment divided by the price of the
bond. The contribution of each payment to the duration of the bond is the relative value of the payment multiplied
by the amount of time (in years) until the payment occurs. Since this bond has semiannual coupons, the years will
include half-years. So, the duration of the bond is:

Year PV of payment Relative value Payment × weight

0.5 $34.15 0.03291 0.01656
1.0 33.31 0.03211 0.03211
1.5 32.5 0.03132 0.04698
2.0 1037.62 0.90366 1.80732
Price of bond = $1,037.62 Duration = 1.90287

26.12 a. The forward price of an asset with no carrying costs or convenience value is:

Forward price = S0(1 + r )

Since you will receive the bond’s face value of $1,000 in 11 years and the 11 year spot interest rate is currently
7 percent, the current price of the bond is:

Current bond price = $1,000/1.0711

Current bond price = $475.09

Since the forward contract defers delivery of the bond for one year, the appropriate interest rate to use in the
forward pricing equation is the one-year spot interest rate of 5 percent:

Forward price = $475.09  1.05

Forward price = $498.84

b. If both the 1-year and 11-year spot interest rates unexpectedly shift downward by 2 percent, the appropriate
interest rates to use when pricing the bond is 5 percent, and the appropriate interest rate to use in the forward
pricing equation is 3 percent. Given these changes, the new price of the bond will be:

New bond price = $1,000/1.0511

New bond price = $584.68

And the new forward price of the contract is:

Forward price = $584.68  1.03

Forward price = $602.22

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26.13 a. The forward price of an asset with no carrying costs or convenience value is:

Forward price = S0(1 + r)

Since you will receive the bond’s face value of $1,000 in 18 months, we can find the price of the bond today,
which will be:

Current bond price = $1,000/1.04733/2

Current bond price = $933.03

Since the forward contract defers delivery of the bond for six months, the appropriate interest rate to use in the
forward pricing equation is the six month EAR, so the forward price will be:

Forward price = $933.03  1.03611/2

Forward price = $949.72

b. It is important to remember that 100 basis points equals 1 percent and one basis point equals 0.01%. Therefore,
if all rates increase by 30 basis points, each rate increases by 0.003. So, the new price of the bond today will
be:

New bond price = $1,000/(1 + 0.0473 + 0.003)3/2

New bond price = $929.03

Since the forward contract defers delivery of the bond for six months, the appropriate interest rate to use in the
forward pricing equation is the six month EAR, increased by the interest rate change. So the new forward price
will be:

Forward price = $929.03  (1 + 0.0361 + 0.003)1/2

Forward price = $947.02

26.14 The financial engineer can replicate the payoffs of owning a put option by selling a forward contract and buying a
call. For example, suppose the forward contract has a settle price of $50 and the exercise price of the call is also
$50. The payoffs below show that the position is the same as owning a put with an exercise price of $50:

Price of coal: $40 $45 $50 $55 $60

Value of call option position: 0 0 0 5 10
Value of forward position: 10 5 0 –5 –10
Total value: $10 $5 $0 $0 $0
Value of put position: $10 $5 $0 $0 $0

The payoffs for the combined position are exactly the same as those of owning a put. This means that, in general,
the relationship between puts, calls, and forwards, all being of the same maturity, must be such that the cost of the
two strategies will be the same, or an arbitrage opportunity exists. In general, given any two of the instruments,
the third can be synthesized.

26.15 a. ABC has an advantage borrowing at the floating-rate, whereas XYZ has an advantage borrowing at the fixed
rate. The two companies can benefit by borrowing at their respective advantageous rates and then entering an
interest rate swap. The swap is set up so that ABC will pay a fixed rate and receives a floating rate from XYZ.

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b. The bank can set up an interest rate swap that will benefit both firms while netting a 2% profit. The swap can
be set up so that the bank receives a 10.5% fixed rate and pays a floating rate of LIBOR + 1% to ABC. At the
same time, the bank receives a floating rate of LIBOR + 2.5% and pays a fixed rate of 10% to XYZ.

The net profit for the bank is:

10.5% – (LIBOR + 1%) + (LIBOR + 2.5%) – 10% = 2%

The net borrowing cost for ABC is:

(LIBOR + 1%) – (LIBOR + 1%) + 10.5% = 10.5%, which is lower than the 11% borrowing rate offered by
the market.

The net borrowing cost for XYZ is:

10% – 10% + (LIBOR + 2.5%) = LIBOR + 2.5%, which is lower than the LIBOR + 3% borrowing rate offered
by the market.

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MINI-CASE: Williamson Mortgage Inc.

1. Jerry’s mortgage payments form a 25-year annuity with monthly payments, discounted at the long-term interest
rate of 5.5 percent. We can solve for the payment amount so that the present value of the annuity equals $500,000,
the amount of principal that he plans to borrow. The monthly mortgage payment will be:

$500,000 = C  𝐴300
0.055/12
C = $3,070.44

2. The most significant risk that Jennifer faces is interest rate risk. If the current market rate of interest rises between
today and the date the mortgage is sold, the fair value of the mortgage will decrease, and Maxine will only be
willing to purchase the mortgage for a price less than $500,000. If this is the case, she will not be able to loan Jerry
the full $500,000 promised.

3. Treasury bond prices have an inverse relationship with interest rates. As interest rates rise, Treasury bonds become
less valuable; as interest rates fall, Treasury bonds become more valuable. Since Jennifer will be hurt when interest
rates rise, she is also hurt when Treasury bonds decrease in value. In order to protect herself from decreases in the
price of Treasury bonds, she should take a short position in Treasury bond futures to hedge this interest rate risk.
Since three-month Treasury bond futures contracts are available and each contract is for $100,000 of Treasury
bonds, she would take a short position in five 3-month Treasury bond futures contracts in order to hedge her
$500,000 exposure to changes in the market interest rate over the next three months

4. a. If the market interest rate is 6.2 percent on the date that Jennifer meets with Maxine, the fair value of the
mortgage is the present value of an annuity that makes monthly payments of $3,070.44 for 25 years, discounted
at 6.2 percent, or:

Mortgage value = $3,070.44  𝐴300

0.062/12
Mortgage value = $467,639.92

b. An increase in the interest rate will cause the value of the T-bond futures contracts to decrease. The long
position will lose and the short position will gain. Since Jennifer is short in the futures, the futures gain will
offset the loss in value of the mortgage.

5. a. If the market interest rate is 4.6 percent on the date that Jennifer meets with Maxine, the fair value of the
mortgage is the present value of an annuity that makes monthly payments of $3,070.44 for 25 years, discounted
at 4.6 percent, or:

Mortgage value = $3,070.44  𝐴300

0.046/12
Mortgage value = $546,805.04

b. A decrease in the interest rate will cause the value of the Treasury bond futures contracts to increase. The long
position will gain and the short position will lose. Since Jennifer is short in the futures, the futures loss will be
offset by the gain in value of the mortgage.

6. The biggest risk is that the hedge is not a perfect hedge. If interest rates change, the fact that Treasury bond
interest is semiannual, while the mortgage payments are monthly, may affect the relative value of the two.
Additionally, while a change in one of the interest rates will likely coincide with a change in the other interest
rate, the change does not have to be the same. For example, the Treasury rate could increase 20 basis points, and
the mortgage rates could increase by 40 basis points. The fact that this is not a perfect hedge simply means that
the gain/loss from the futures contracts may not exactly offset the loss/gain in the mortgage.

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