This Document Contains Chapters 24 to 26 CHAPTER 24 INTERNATIONAL FINANCIAL MANAGEMENT CHAPTER IN PERSPECTIVE When considering international cash and investment flows, foreign exchange rates and political risks are an added dimension for the financial manager. These risks are covered thoroughly for your students in this chapter. Starting with a discussion of foreign exchange rates using the exchange rate table from The Globe and Mail, a discussion of why spot and forward rates differ is analyzed. This section, featuring Table 24.1, is a very effective method for explaining the interrelationship of spot and forward exchange rates, interest rates, and inflation rates. The need and interest in integrating international finance material throughout the course is easily accomplished by using Sections 24.1 and 24.2 anywhere you wish in the course. When hedging is discussed in the Risk Management chapter, foreign exchange hedging, Section 24.3, is easily added to the assignment. When capital budgeting is covered, the international dimensions related to exchange rates and cost of capital fit very well. Covering international perspectives early in the course and reinforcing with current events from newspapers, etc., is a very effective way to teach these important, but heretofore ignored, aspects of financial management. CHAPTER OUTLINE 24.1 FOREIGN EXCHANGE MARKETS Spot Exchange Rates Forward Exchange Rates 24.2 SOME BASIC RELATIONSHIPS Exchange Rates and Inflation Inflation and Interest Rates Interest Rates and Exchange Rates The Forward Rate and the Expected Spot Rate 24-9 This Document Contains Chapters 24 to 26 Some Implications 24.3 HEDGING EXCHANGE RATE RISK Transaction Risk Economic Risk 24.4 INTERNATIONAL CAPITAL BUDGETING Net Present Value Analysis The Cost of Capital for Foreign Investment Political Risk Avoiding Fudge Factors 24.5 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 24.1 FOREIGN EXCHANGE MARKETS A. The electronic trading of foreign currencies between banks, dealers, and businesses is called the foreign exchange market. B. Unlike the Toronto Stock Exchange, the foreign exchange markets have no central marketplace, and participants trade via sophisticated communications systems. Spot Exchange Rates A. The amount of one currency needed to purchase one unit of another currency is called the exchange rate. The spot exchange rate is a quote for an immediate transaction. B. Foreign currency exchange rates are quoted two ways. The first is the indirect quote and lists the amount of foreign currency that it takes to purchase one Canadian dollar or currency per Canadian $. The cost of a Canadian dollar in terms of the U.S. dollar was 1.023541. See Table 24.1. C. The second, and the reciprocal of the above, is the direct quote (used for most currencies in the Table 24.1). It quotes the Canadian currency cost of one unit of foreign currency. 24-9 Forward Exchange Rates A. A forward exchange rate is the price of foreign currency at some future date. The forward exchange rates may trade at a premium or discount relative to the spot rate. Using indirect exchange rate quotes, a spot/forward differential is equal to the spot minus the forward divided by the forward and annualized. When the forward rates buy less Canadian, as in the text case of the yen, the differential is quoted at a yen forward premium (expected to appreciate against the $) and the dollar is at a forward discount (expected to depreciate against the yen). The sign, (+ or -), of the foreign currency forward differential indicates a premium (+) or discount (-) or the expected direction of the value of the foreign currency/$. B. Foreign exchange futures contracts are traded on futures exchanges and are available for hedging foreign exchange risk. 24.2 SOME BASIC RELATIONSHIPS A. There are several basic relationships between spot rates, forward rates, expected relative country inflation rates, and country interest rates that are fundamental to international financial management. B. The spot/forward differential reflects market expectations of relative country inflation rates. Interest rate differentials reflect the spot/forward differential which reflects the expected relative country inflation rate. Investors are seeking a real, inflation adjusted, exchange rate adjusted, after-tax return, and price spot/forward differential to provide that return. Exchange Rates and Inflation A. The economic law of one price theory states that the prices of goods in all countries should be equal when translated to a common currency. B. Inflation is the decline in purchasing power of a currency (or an increase in the price level in a currency). C. For the law of one price to hold, exchange rates must vary with inflation to provide similar values for currencies or purchasing power parity (PPP) across countries. 24-9 D. Estimated future spot exchange rates (forward rates) closely reflect estimated relative inflation rates between countries. Inflation and Interest Rates A. Investors’ real, nominal adjusted for inflation, return is the one that counts. B. The international Fisher effect is a theory that says that real interest rates in all countries should be equal, with the differences in nominal rates reflecting differences in expected inflation. C. Countries with high inflation rates tend to have high subsequent interest rates. See Figure 24.3. Interest Rates and Exchange Rates A. International lending (investing) and borrowing entail transferring balances between currencies when lending and borrowing occurs. This concern of future exchange rate levels when the investment is complete or when returns/payments are made forces most to buy forward exchange contracts for adverse exchange rate movements. Capital tends to flow to its highest real, risk adjusted rate of return. B. Market forces and capital flows tend to provide interest rate parity among countries in that spot/forward foreign exchange rate differentials tend to offset interest rate differences between countries and tend toward offering investors 24-9 nearly the same exchange rate adjusted, rate of return in all countries and is called the expectations theory of exchange rates. Forward rates are expected spot rates to provide interest rate equivalency. The Forward Rate and the Expected Spot Rate A. Forward rates are expected future spot rates. B. The percentage spot/forward differential (premium or discount) reflects the exchange markets’ estimate of the percentage change in the exchange rate between two countries. C. While forward rates are not good predictors of actual future spot rates, on average the forward rate is equal to the future spot rate. Some Implications A. The above four relationships are long-run, “tending toward” relationships that tend to hold over the years. B. International financial decision makers should implant those relationships and be wary when betting against them. 24.3 HEDGING EXCHANGE RATE RISK Transaction Risk A. Foreign exchange risk is the variability in returns and cash flows (gains and losses) which occur when one must transfer values from one currency to another. B. There are two types of foreign exchange risk. Contractual risk is the variability of outcomes occurring when a specified currency exchange must be made on a given date. Noncontractual risk includes the general business impact of changing exchange rates on importers and exporters, investors, etc. C. One may assume foreign exchange risk and take the loss/gain consequences of changing foreign exchange rates or remove the impact of varying exchange rates by hedging. 24-9 D. One may hedge foreign exchange risk by trading in forward foreign exchange contracts, foreign exchange futures contracts, or financial futures option contracts. See the Enterprise Oil example in Table 24.4. E. The cost of the hedge is the difference between the forward rate and the expected spot rate when payments are made. F. Hedging foreign exchange risk makes sense for it focuses the business manager on “business” and not exchange rate forecasting and does not cost much. Economic Risk A. Economic exposure to the exchange rate arises because exchange rate fluctuations affect the competitive position of a firm, even if the firm neither owes nor is owed foreign currency. B. Operational hedging by balancing production closely with sales reduces the economic exposure of a company to the exchange rate. C. Financial hedging can be used to hedge the economic exposure to the exchange rate if operational hedging is not an option. 24.4 INTERNATIONAL CAPITAL BUDGETING Net Present Value Analysis A. The decision-making rules in international investments and currencies are essentially the same process as with domestic projects. If NPVs are positive, make the investment. B. The exchange rate risk consideration may be handled two ways. First, the estimated foreign cash flows are converted to dollars at the projected exchange rates and discounted at the dollar cost of capital. Second, in order to avoid making estimates of future exchange rates, calculate the future foreign denominated cash flows and discount at the foreign cost of capital. The foreign currency NPVs are then converted to domestic currency at the current spot rate. C. Under the assumptions developed above both evaluation methods should give the same investment decisions. D. The key point is not to make investments dependent upon specific, estimated future exchange rate movements. Select the investment based on the NPV and hedge the foreign exchange rate. 24-9 The Cost of Capital for Foreign Investment A. An international investment is an additional investment to the total portfolio, so the relevant risk of the added investment is its effect on the total portfolio risk. B. The discount rate on international investments should reflect this incremental risk effect on the total investment portfolio. Political Risk A. When multinational companies invest abroad, their financial mangers need to consider the political risks that are involved. By this, we mean the threat that governments will change the rules of the game after an investment is made. B. Political risk refers to any change in the value of a firm arising from political events which are often unanticipated. Such risk can be faced by firms operating in domestic as well as international environments. Businesses in every country are exposed to the risk of unanticipated actions by governments or the courts. But in some parts of the world foreign companies are particularly vulnerable. Avoiding Fudge Factors A. The usual international risk adjustment practice is adding an increment to the discount rate to cover the risks of expropriation (political risk), foreign exchange restrictions, and tax changes. B. A better method is to specify the international risks and their likely impact on cash flows and reduce the expected future cash flows. 24.5 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - In Figure 24.1 we relate the interrelationships between spot and forward rates, interest rates between countries, inflation differentials, and expected spot rates and forward rates. This is an excellent method of presenting these international basics. One suggestion is to enlarge Figure 24.1 and then prepare four other transparencies (each of the related pairs) so that they may be stacked on the overhead. Finally, when all four are on the overhead, one is back to the total figure. It is a very effective tool for your class presentation. Student Career Planning - While a few business schools are giving their students an adequate international perspective, most are not. It is the students’ responsibility to develop this knowledge and skills on their own. Encourage your students to consider the 24-9 following: 1. Extend their foreign language study. Some courses include cultural and institutional materials of specific countries. 2. Take a course in international finance, international economics, or trade. These are usually “meaty” courses but have lasting benefits. 3. Discourage students from majoring in international business at the undergraduate level. Major in a functional area and take electives in the better international business courses or take a minor. Businesses hire effective people with functional, computer, and interpersonal skills. They will send only the most effective and culture-based people into international settings. Advise students to keep their language skills up and major in personal development. 4. Several internships and student tours are focused toward the internationalization of Canadian students. Many include a semester of study abroad. For the students that could care less about an international perspective, remind them that their domestic company is just one transaction away from foreign ownership and a new boss. It is likely to happen and college is the best place to lay the foundation for preparedness. Internet Exercises - Most of the better Internet sites, such as Yahoo Finance, provide international financial market data, from exchange and international interest rates to international market indices. One of the better sites for international market data is Bloomberg.com. Another reference site that is useful to link to your international page is Currencies of the World, supported by PACIFIC Exchange Rate Service and by Professor Werner Antweiler of the University of British Columbia. The Department of Finance, Government of Canada website is also quite useful. http://fx.sauder.ubc.ca/currency_table.html Currencies of the World provide an excellent reference to the names of the currencies of countries around the world. From the afghani of Afghanistan to _______(which country would you guess is at the end of the alphabet?), by clicking on the names of the currencies, the Currencies of the World table directs you to the corresponding Wikipedia entry. The table also provides the international standard for currency codes (ISO-4217) along with currency symbols. http://www.bloomberg.com Bloomberg.com is the Internet site of Bloomberg L.P. and is an excellent reference and learning site for finance students. Bloomberg provides various international financial market data from the link list on the left side of their home page, as well as access to their 24-9 international sites at the top of the home page. Under the Markets link, you can find the bond yields over the term structure for U.S. Treasuries, Canadian, French, German, Italian, Japanese, and British markets. Click on the World Indices and review the more common stock indices around the world. Review the currencies of the world under the Currency Rates link along with the Key Cross Currency Rates for the currencies of the larger countries. The currency calculator quickly gives you the equivalent foreign currency cost of an amount of another currency. This latter link is a good one for your international finance page! Bloomberg also provides excellent company research data and financial market data. One of the better financial sites on the Internet and a good link for your financial markets page. http://www.fin.gc.ca/fin-eng.asp This site, maintained by Department of Finance Canada provides useful information on a variety of subjects including international issues. For instance, this site provides information on tax treaties between Canada and other countries. The site provides links to international organizations such as the World Bank and the IMF. 24-9 CHAPTER 25 OPTIONS CHAPTER IN PERSPECTIVE The growth of financial derivative securities for hedging and speculating has been dramatic. With lenient margin requirements, the speculator is provided an exciting place to play. For the risk manager, hedging with derivatives, the subject of the next chapter has provided the opportunity to decide what risks to accept in the business and which to hedge. In this first of two chapters associated with risk management, options, from exchanged- based traded to contract options in securities to imbedded options in real assets, are discussed. The “Financial Alchemy with Options” provides a discussion of investor payoff positioning. The discussion of option value factors provides insight as to what makes an option valuable. Traditionally, financial management texts espoused financial flexibility. What were they talking about? Options, at some cost, provide the financial manager choices for the future. This chapter comes at the end of the textbook, but the materials related to exchange- traded, contract, and imbedded options are important today and should be a part of the scope of a financial management course, just as an international perspective should be covered. CHAPTER OUTLINE 25.1 CALLS AND PUTS Selling Calls and Puts Payoff Diagrams are Not Profit Diagrams Financial Alchemy with Options Some More Option Magic 25.2 WHAT DETERMINES OPTION VALUES? Upper and Lower Limits on Option Values 25-1 The Determinants of Option Value Option-Valuation Models 25.3 SPOTTING THE OPTION Options on Real Assets Options on Financial Assets 25.4 SUMMARY APPENDIX 25A: THE BLACK-SCHOLES OPTION VALUATION MODEL (Available in Connect) TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 25.1 CALLS AND PUTS A. Options, the right to act within a specified period of time, are widespread in business, financing, and investment operations. B. Options have value because they specify the ability to take action whether buying, selling, expanding, or doing nothing. C. Standardized option contracts on a variety of financial assets began trading on the Chicago Board Options Exchange (CBOE) in 1973. Canadian option contracts are traded on the Montréal Exchange (or Bourse de Montréal). Investors and businesses trade options to speculate. More importantly for businesses and investors, options are traded to hedge price risk, the risk of unfavourable price movements in their business or portfolio. D. A call option gives the owner the right to buy an asset at a specified price on or before a specified date called the exercise date. A buyer of a call option may exercise the option in the option period or let it expire. In the case of the Toronto Dominion Bank (TD) options, the owner of the call would exercise the call (right to buy TD at $84) if the price of RIM exceeded $84. If the price remains below $84, the call will not likely be exercised. See Figure 25.1 (a). 25-2 E. A put option is a right to sell an asset at a specified exercise price on or before the exercise date. A buyer of a put would exercise if TD fell below $84 by buying TD below $84 and selling it for $84. If the price remains above $84, the put will not be exercised. See Figure 25.1 (b). 25-3 Selling Calls and Puts A. Traded options on the CBOE, the Montréal Exchange, and other exchanges are issued by the call and put writers, usually investors. The positive/negative payoff of a call/put buyer is offset by call/put writers or option sellers. B. The buyer of calls and puts has a limit on the negative payoff equal to the cost of the option paid to the writer. The writer’s negative payoff potential may be very high, especially if the writer does not own the underlying asset, such as TD stock.. Payoff Diagrams Are Not Profit Diagrams A. Payoff diagram shows only the possible payoffs when the option expires. It does not account for the initial cost of buying or the initial proceeds from selling an option. B. Profit diagram shows both the possible payoffs when the option expires and the initial cost of buying or the initial proceeds from selling an option (see Figure 25.3). Financial Alchemy with Options A. Two possible conditions and payoffs are discussed to provide an indication of why investors may trade options. B. As a protective put or “portfolio insurance,” an investor owns stock and seeks to protect its current gains (protect against falling stock prices) by buying a put option on RIM. For the cost of the option (insurance premium) the investor has upside price opportunity and downside protection. If the price falls, the gain in the option will offset the decline in the stock value. See Figure 25.5. 25-4 Some More Option Magic A. Figure 25.5 shows that the combination of the stock and put option always provides the same payoff as holding the call option plus investing the right amount of money in a bank account. This gives us the relationship put-call parity: Value of stock + value of put = value of call + present value of exercise price 25.2 WHAT DETERMINES OPTION VALUES? Upper and Lower Limits on Option Values A. While an option is worthless when expired, why does an option have a positive value before expiration? B. The upper boundary on the value of a call option is the share price value, while the lower boundary on the value of a call is the payoff if exercised immediately. C. The value is related to the stock price. The call is always worth more than its value if exercised now (lower bound) and never worth more than the stock price itself (upper bound). D. The value of the option lies between the upper and lower bounds. The value will lie on the curved upward sloping line in Figure 25.6. Figure 25.6 25-5 The Determinants of Option Value A. Given the exercise price, the value of a call option increases as the stock price increases. B. Three key points on the option value curve, Figure 25.6, are important reference points. C. At Point A, when the stock is worthless, the option is worthless. At Point B, when the stock price becomes very high, the option price approaches the stock price less the PV of the exercise price. The value of a call increases directly with increases in the rate of interest and the time to expiration. And at Point C, the option price always exceeds its minimum value, except when the stock price is zero. There is always a chance that the stock price will advance to the exercise price. D. The value of an option is directly related to the stock price volatility. The greater the volatility, the greater the chance that the stock will move above the exercise price. E. Five factors determine the value of a call or put option. Table 25.4 summarizes the relationship between each of the five factors and the prices of a call option and a put option: 25-6 Option-Valuation Models A. The best method for estimating the value of an option is to find the combination of borrowing and making an investment in the stock that exactly replicates the payoffs of the option. In a competitive market, securities or portfolios with the same future cash flows must sell for the same current price. Since the cost of the borrowing/buying share strategy is known, it must equal the cost of the call option. B. A simple binomial option-valuation model is presented on page 796. It is based on the idea of finding a combination of borrowing and share purchase that has exactly the same payoffs as a call option. It simplifies the problem by assuming that the future stock price can only be one of two possible values. C. Work by Black and Scholes developed this option value theory to create the Black-Scholes option pricing model. They found the formula for pricing a call option when the stock prices are changing continuously. D. The Black-Scholes formula is widely used by traders, investment bankers and financial managers to price a wide variety of options. Appendix 25.A provides the basic intuition of the Black-Scholes model and examples of how to use it. 25.3 SPOTTING THE OPTION A. Options, either explicit or implicit, are present everywhere in business and investments. 25-7 B. The challenge is to identify the option present and to consider the value of the option. Options on Real Assets A. Real options or the implicit (implied with ownership) options on real assets such as plant, land, etc., are present in any business setting. B. The first real option is the option to expand an investment, such as a production facility, at a future date. This call option, option to buy more production facilities, is often called flexibility. C. The business also has the option to abandon an investment. This option to sell (put) or quit is valuable, especially when the value of the underlying asset is volatile. D. All aspects of project management from expansion, contraction, delay, or abandonment contain real options. Options on Financial Assets A. Options to participate in the common stock are often attached to debt securities. A warrant is a right to buy (call) shares from a company at a stipulated price before a set date. B. The right to participate in the equity is valuable to the bondholder. Warrants may be detachable and trade separately from the bonds. Investors value warrants like they value a call option: warrants provide the opportunity to purchase the stock at a fixed price for a set period of time. C. A convertible bond is a bond that may be exchanged for a specified number of common shares. The convertible bond has a call option on a number of common shares. A conversion ratio of 20 shares on a $1000 bond has a conversion price of $50 (1000/20). The conversion price is like an exercise price. D. The value of a convertible bond is driven by the bond value when the stock price is low, relative to the conversion price, and becomes related to the stock value when the stock price approaches and passes the conversion price. The bond value establishes a floor or minimum price for the convertible bond; the upper bound is unlimited, dependent upon the value of the common stock. The value of the call option is equal to the difference between the convertible selling price and its bond value. E. Callable bonds include a call option held by the borrower or issuer to repurchase or refund the bond before maturity at a specified call price. 25-8 F. Lenders are likely to lose their high rate callable bonds if interest rates decline, so they demand a higher rate of return. The value of the call option is the yield on the callable bond less the yield on a noncallable, similar bond. 25.4 SUMMARY Online APPENDIX 25A: THE BLACK-SCHOLES OPTION VALUATION MODEL A. Central to valuing a call option is to construct an investment strategy using traded securities that provides exactly the same payoff as the option. Using traded securities means that the price of the investment strategy is known and hence equal to the price of the options replicated. B. The general form of the investment strategy is to combine the purchase of some of the underlying shares and borrowing: Value of call option = delta × current stock price – bank loan where delta is the amount of stock to purchase. C. Also central to the valuation of a call option is to model the change in the stock price over time. With the binominal model, the stock price has only two possible changes, allowing for only two possible future prices. The brilliant insight of Professors Black and Scholes was to generalize the model to allow for continuous price changes. This led to the Black-Scholes option pricing model: Value of call option = delta × current stock price – bank loan = N(d1) × P – N(d2) × PV(EX) D. Although the Black-Scholes model assumption of continuous price changes implies continuous adjustment of the holdings of the stock to keep replicating the option, it works quite well in practice, where continuous adjustment is infeasible. The formula has been modified to price foreign currency options, options on bonds and futures. PEDAGOGICAL IDEAS General Teaching Note - The best way to teach the concepts of options is to begin with exchange-based options on a realistic example (company) that students know. Walking through several scenarios with a call, then a put option contract establishes the payoff possibilities and establishes the terms with the students. The spotting the option in real assets is difficult for some students who do not conceptualize well. Using their car as an example seems to get the concept embedded as well as anything. 25-9 One more suggestion related to practical examples. For years I have used an annual report of a student-known company as a daily reference and for many assignments from ratios to capital structure to dividend policy. The companies, via the shareholder relations 800 number and Investor Relations link from their home page, will give you as many annual reports as you wish, pass them out, and reference the shareholder communications efforts of the firms. Alternatively, download the annual report from www.sedar.com. If multiple copies are a problem, include the annual report in your campus-published notes or readings packet (always bound with pagination). Student Career Planning - Students feel that everything in their world is changing rapidly, and they are right. But often the changes are cosmetic and usually the basis of the change has a precedent. The problem the student has is the lack of perspective provided us by our longevity. My advice to students is to study a little history. Business history has a lot to offer the young aspiring businessperson who is about ready to tackle the world. With just a little reading before the light goes out, they will find that they will not have to “invent the wheel” all over again in many areas, nor have to take every lesson in the “school of hard knocks” right on the chin. Over the years successful business people and professional historians have penned messages to the next generation. Annually, many years of wisdom are polished, published, and placed in your library. Recently, books by Walter Wriston, Henry Kaufman, Lee Iacocca, Bill Gates, and others have appeared, each with several messages for the young person. As they study history, students will find repetitive patterns, economically, politically, etc. Such pearls of wisdom as “there is a business cycle,” or “nothing lasts forever,” or as the great philosopher Bob Dylan has sung, “What goes around, comes around,” are facts of business life that one can learn to anticipate. Most campuses have business historians offering a variety of interesting periods. Much is new; much is repackaged and can be anticipated! Internet Exercises - Exchange traded options offer opportunities to leverage a speculator’s capital and/or an opportunity to manage the risks faced by businesses or investors. There are many exchanges that trade options, and all offer educational information from simple to advanced. Two favourites are the Chicago Board Options Exchange (CBOE) and the American Stock Exchange (ASE). In the review below, the focus is on extending the excellent chapter presentation to provide the interested student with more practical information about the use of options and the details of trading options. www.cboe.com The Chicago Board Options Exchange (CBOE) has an educational Internet site that offers a reinforcement and practical extension of the chapter materials. Click the 25-10 “Education. Students can register for online courses. www.m-x.ca The Montréal Exchange (or Bourse de Montréal) is the site for Canadian options and futures. It has several option calculators listed under "Trading Tools". Click on “Education” to access some of its education information. 25-11 CHAPTER 26 RISK MANAGEMENT CHAPTER IN PERSPECTIVE The business and financial risks faced by financial managers today are considerable, especially as globalization broadens and competition increases. Today a manager must recognize what risks are present in the business, the range of possible outcomes associated with the risk (probability of outcomes and financial consequences of each outcome) and the extent to which, and at what cost, the risks may be reduced, accepted, or shifted to others. The management of risk has always been a key financial manager function, but the orientation until recently was focused only on the pure risk (risks of real assets) faced by the business. A risk management approach to all business and financial risks is developing. This chapter is one of the first to appear in a financial management text. The financial manager who wishes to control the level of specific risks so identified may eliminate them by avoiding the risk, remove by contract, such as with contractual options, or hedge where cost justified and available, by using “off-balance sheet” or “off business” hedging tools such as futures, forwards, or swaps. Such hedging contracts are either exchange-based or are, as with forwards, negotiated with other parties with a mirror image risk to hedge or via a hedge dealer who will contract between parties as with swaps. CHAPTER OUTLINE 26.1 WHY HEDGE? The Evidence on Risk Management 26.2 REDUCING RISK WITH OPTIONS 26.3 FUTURES CONTRACTS The Mechanics of Futures Trading Commodity and Financial Futures 26.4 FORWARD CONTRACTS 26-1 26.5 SWAPS 26.6 INNOVATION IN THE DERIVATIVES MARKET 26.7 IS “DERIVATIVE” A FOUR-LETTER WORD? 26.8 SUMMARY TOPIC OUTLINE, KEY LECTURE CONCEPTS, AND TERMS 26.1 WHY HEDGE? A. Hedging involves incurring a cost to reduce the risk of adverse price movements. B. Hedging makes financial planning easier and allows the manager to focus on internal, controllable production efficiency rather than external, noncontrollable price speculation. C. One tool for hedging involves contracting in financial derivatives, contracts whose value is derived from the value of other financial or real assets. D. Hedging involves contracting to gain in a derivative contract if a loss (or opportunity loss) should occur in the business or real or financial assets that you own. Thus hedging is used to offset the impact of an adverse change in the value of real or financial assets the company owns. The Evidence on Risk Management A. There are three ways to manage risk: using real options to limit risk, purchasing insurance policy against certain risks, and entering specialized financial contracts to eliminate price risk. 26.2 REDUCING RISK WITH OPTIONS A. Hedging with options provides protection from adverse price changes for a large number of real and financial assets from wheat and oil to Government bonds. B. The hedger selects the option exchange contract that is best associated with the price risk (risk of adverse price movements) at hand. There is also a large volume of option contracts written off of the exchanges between hedgers, who have price risk in a commodity or financial asset, and a speculator, who has no cash, current or spot position in the asset. 26-2 C. Hedging is performed by taking a position in the option contract, or other hedging contract, so that adverse price movements in the business (raw material costs increasing) are offset by gains in the hedging contract. It is assumed that the business or investor will continue their business by buying/selling in the spot or cash market. D. If a business will be adversely affected by rising prices, such as a processor of agricultural goods, a call option will offer one side price protection for a fee, the price of the call. If raw prices rise for the business, they will rise to and above the strike price, providing option contract gains to offset business losses (opportunity costs of buying at a higher price). If prices fall, the call option holder will let the option expire. Onnex’s insurance strategy is illustrated in Figure 26.1(a)-(c). 26-3 E. If a business, such as a farmer or manufacturer, faces the risk of falling prices for its production, it may purchase put options or options to sell. If corn prices fall between planting and harvest, the economic loss in the business is offset by the gains in the put contract. The farmer is selling corn at a specified price when the puts are purchased. If prices fall, the option contract is in the money, offsetting the reduced margins in the business. If prices rise, the put option is never exercised. The cost of the option is the insurance premium spent to avoid adverse price movements. F. Option contracts may protect holders of financial assets. A Government bond investor may be worried about the Bank of Canada raising interest rates. If rates rise, bond prices will fall. How can an investor hedge the risk of interest rate increases or falling bond prices? Yes! Buying Government bond puts provides the downside protection. Focus on the direction of the adverse price movement and protect with a counter position in the option contract. G. Unlike futures contracts and forward contracts, hedging with options provides one-way insurance protection against adverse price movements. H. However, options are not free – the cost of the insurance is the price paid to buy the call or put. Review the factors affecting the prices of puts and calls to show that the better (more complete coverage) is the insurance from the option, the more expensive is the option. For example, when using a call option as protection against rising input prices, the exercise price determines maximum price paid for the input. Thus, the lower the exercise price on the call option, the more complete is the insurance. However, the price of a call option is higher for lower a lower exercise price – making the call option more expensive insurance. 26-4 26.3 FUTURES CONTRACTS A. Futures contracts, exchange-traded contracts to buy or sell a standardized amount of an asset at a specified price at a specified date, are frequently used to hedge price risk. B. For a small cost of a margin deposit, a farmer can protect against price declines by selling canola futures with total contracts approximating production. The maturity selected will be slightly longer than the period of price risk. If canola prices fall, the daily mark-to-market procedure of futures exchanges will add deposits to the farmer’s account. Unlike option contracts, if prices for canola increase, the gain in the business is offset by losses on the sale (short position) of corn futures. Figure 26.2 (a)-(c)). 26-5 The Mechanics of Futures Trading A. The futures contract with the exchange is highly liquid and can be reversed quickly should price risk in the business cease. B. A financial manager, worried about higher interest rates during a heavy borrowing period, can hedge higher rates and lock in today’s rates by selling T-bill or Eurodollar futures contracts. If rates rise, the business will pay more interest, but rising rates are associated with falling financial futures contract prices. As rates rise, the exchange will credit the financial manager’s account. The manager is 26-6 gaining for he or she has sold a contract that can be reversed later at a lower price, or he or she has locked in the cost of funds when the futures contract was sold and current rates are now higher. Commodity and Financial Futures A. Commodity and financial futures exist in areas where there is extreme price variability. Futures began first in commodity markets, and became very popular later in the 1970’s as interest rates became extremely volatile. Futures lock in prices today, avoiding both adverse and favourable future price movements. 26.4 FORWARD CONTRACTS A. Forward contracts are agreements to buy or sell an asset in the future at an agreed price. Forward contracts are designed specifically for the risk, amount, and period, whereas futures contracts are standardized contracts as to amount, time, and specific commodity or financial asset. B. Forward contracts entail delivery; futures seldom entail delivery. Forwards are not marked to market daily like futures, but are settled at maturity. This greatly increases the risk of default, relative to futures contracts. 26.5 SWAPS A. A swap is an arrangement between two traders to exchange a series of future payments on different terms. B. A swap hedge entails trading a possible adverse price movement for known cash flows with a party that has the opposite need. In the chapter example Moose was able to improve the terms of its loan for its foreign subsidiary and reduce foreign exchange risk by borrowing in Canada at favourable rates and swapping the dollar loan commitment for a series of annual deutsche marks. C. Swaps are often used to trade variable and fixed interest cash flows in the future. Like options and futures and other derivatives, they can be used to hedge business risk or to speculate on future price or interest rate movements. (Figure 26.3) Company Swap Dealer Fixed rate pmt LIBOR pmt LIBOR pmt To bondholders 26-7 26.6 INNOVATION IN THE DERIVATIVE MARKET A. Many new derivative contracts are developed for hedgers/speculators each year by exchanges or dealers, however only the contracts that generate sufficient volume survive. B. Weather-related contracts (insurer calamity or energy) contracts have been popular lately, but as risk management needs arise, so will contracts to meet the market need. 26.7 IS “DERIVATIVE” A FOUR-LETTER WORD? A. Derivative infamy emanates from the bad results of speculating in derivatives that make good news releases. When speculating, an investor is not attempting to offset unfavourable changes in another asset, real or financial, but B. Businesses and investors use derivative contracts to hedge (reduce) a variety of risks they face. Little is heard about this effective risk management activity from the newspapers. C. The use of derivatives by financial institutions for speculative purposes has been heavily criticized especially in light of the recent financial crisis. The role of instruments such as Credit Default Swaps has been the subject of much discussion and controversy 26.8 SUMMARY PEDAGOGICAL IDEAS General Teaching Note - How to hedge with external hedging instruments is often challenging to students. They can find the most appropriate futures contract and identify the risk, but “guess” when the buy or sell decision comes. There are two ways to figure out how to hedge with futures, futures options, options, or swaps. The first, which works consistently with commodities hedges, is the long/short analysis. One first assesses the “spot” or current position of the business, such as the farmer will have (long position) corn, so a short hedge (sale of contract) is needed. Beware that the long/short analyses work only with commodities and foreign exchange, and not always with financial futures. A second methodology, called “hurt if analysis,” is better for it forces one to make an economic analysis of the risk, how (direction and extent) it might affect a business 26-8 situation, and establishes a hedge position that will pay off if losses occur in the business. A corn farmer will be hurt if corn prices drop during production. Assuming the business will always operate in the spot or cash markets or sell the corn later at the market price, the farmer would take position in corn futures or corn call options on futures that will gain if corn prices fall. This position can only be a short selling position. If corn prices fall, the farmer loses (opportunity loss) in the spot, cash, or in the business, but has a gain in the futures by covering the short later at a lower price or by daily mark-to-market credits to his account as corn prices fall. I like to cover the terms and issues in a commodity futures hedge before moving to a financial futures hedge. Financial futures prices move inversely to interest rate changes, but it is the expected interest rate or futures price movement that determines the long/short position to take. Internet Exercises - One of the better non-Canadian based financial Internet sites that we have not mentioned is Hoovers.com. Of the Canadian-based websites, we suggest www.globeinvestor.com for free information. Other websites exist, such as www.adviceforinvestors.com, but require subscriptions to access their vast information. www.hoovers.com Hoover’s Online is an excellent site for the business student researching industries, companies, and IPO activity. It is definitely focused on U.S. companies but does cover some Canadian companies. Click the "Companies", and you can extensively research a company by entering the stock symbol. Hoover’s also has an extensive list of both “public” and “private” companies. For students who are interested in a line of business, the “Industry” listings and links are excellent. From industry analyses to links to industry trade associations, the “Industry” research opportunities are extensive. 26-9 Instructor Manual for Fundamentals of Corporate Finance Richard A. Brealey, Stewart C. Myers, Alan J. Marcus, Elizabeth Maynes, Devashis Mitra 9780071320573, 9781259272011
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