DISSERTATION - HEDGING OPPORTUNITIES, STRATEGY AND NEED

ACADEMY OF ECONOMIC STUDIES BUCHAREST

FACULTY OF INTERNATIONAL BUSINESS AND ECONOMICS

MASTER PROGRAM IN MANAGEMENT OF INTERNATIONAL PROJECTS

DISSERTATION

HEDGING OPPORTUNITIES, STRATEGY AND NEED

EXECUTIVE SUMMARY

Reducing or cancelling risk attached to a business (investment) is critical in finance and financial activities of economic agents. Hedging as strategy or result of business strategy has given birth to highly sophisticate financial instruments over the last years and its potential is still underexploited at global level. Hedging activities have proven to be not only ways of reducing risks, but also considerable revenues drivers especially for hedging dealers, such as banks or hedge funds, and even more surprisingly, in certain situations, drivers of risks for all parties involved.

Hedging has been considered for many years to be an exclusive strategy of reducing risk exposure of businesses. As international business environment became more and more sophisticated and transactions of high values and risk exposure to different kind of tradable goods, currencies and even to non-tradable but highly important fluctuating situations (such as weather) began to have significant influence on all sorts of business investments, hedging started to be considered not an option and strategy in itself, but a need. As result, derivatives transactions gained high importance and volume over the last years, and investors became to consider hedging opportunities as a normal flow of business transactions. Consequently, many agents acting on behalf of their clients that needed to hedge have reported highly increasing profits from hedging activities. In this context, the need to be informed of hedging opportunities comes close to any kind of risk management strategy both for financial and non-financial companies.

The overall goal of this paper is to clarify the notion, the evolution, the instruments, the use and applicability, and nevertheless the mechanisms of hedging as a strategy or result of business strategy for both financial (especially banks) and non-financial (multinational) companies in the 21^st Century.

Special focus will be given to swaps, both currency and interest rate swaps, as many studies insist on their spectacular increasing use as reflected in number of contracts, parties involved, and volumes at global level over the last years.

I. INTRODUCTION

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is mainly recognized as a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity. However, if we take hedging as a need to counterbalance risks that derive from investment decisions, from an initial strategy to invest, we may also consider hedging as the result of a strategy. In this view, banks are the most interesting subjects to analyze. That is mainly because a bank's gain derives from risk exposure on behalf of its clients. Even if a client chose to reduce its risk exposure through a financial instrument provided by a bank, from its client strategy to minimize risk exposure, the bank is also going to gain at least a premium. In this case is obvious that hedging is the result of a strategy, of the client's strategy to reduce its risk exposure through a hedging instrument. Moreover, it is also clear that hedging always leads to bilateral gains for parties involved: the bank as agent gains from the transaction at least a premium and the client also gains by reducing its risk exposure. Overall, hedging can both be considered a strategy and the result of a strategy.

Hedging can create high returns in both good and bad markets. However, high returns come only at the expense of high risk.

Hedging strategies are not only desirable, but needed and alternative investments (through derivatives trading) have reached an all times peak over the last years.

As main players, banks often come into discussion when hedging is explained because of their dual position: they are both buyers of hedge for their own need (if their net exposure requires hedging their liabilities) and sellers of hedge for their clients need to cover risk exposure to market volatility. On the selling side, banks act more like hedging agents and dealers, than arrangers for their clients, while on the buying side, they act exactly like their clients like any other corporate entity that needs to hedge its risk exposure to market fluctuations. That is mainly the reason why this study will focus on financial institutions (banks) hedging activities on both sides.

Hedging to Banks

Banks enter into a large number of transactions in the ordinary course of their operations. Some of these transactions carry financial risk. For example, with individual loans the risks typically include a risk of debtor default or risks presented by changing interest rates for variable rate loans or imminently mature loans (whose principal likely will be reinvested at a new interest rate). Typically, banking regulations require that banks own other instruments whose behavior counterbalances risks presented by the first instruments. This is called 'hedging.' Risks presented by a first, typically large, set of instruments (called, 'hedged items' herein) are counterbalanced by performance of a second, typically much smaller, set of instruments (called, 'hedging instruments' herein), such that when risk rises in the hedged items, risk falls in the hedging instruments. The hedged items and the hedging instruments may be grouped into one or more hedging relationships. On a cash flow basis, for each hedging relationship, the performance of the hedging instruments must match the performance of the hedged items within a predetermined criterion. As noted, these criteria typically are established by regulation but they also may be set by a bank's individual hedging policy.

To ascertain whether a bank's financial positions meet the prescribed hedging requirement, a system for evaluating cash flows of each hedging relationship's hedged items and hedging instruments may be used. The types and number of transactions into which a bank enters may constantly change and instruments held by a bank may mature. Since a bank's hedged items and hedging instruments constantly change, a bank must actively manage its hedging positions. If a bank determines that it does not own sufficient hedging instruments to effectively hedge a set of hedged items, the bank must search for and purchase additional instruments to render its hedging position compliant.

Currently in both financial and non-financial institutions, derivatives fulfill their traditional functions of price discovery and hedging by rationalizing loan pricing and by hedging risks that bankers, for financial safety, must transfer to the markets. Used for hedging, derivatives serve the economic purpose of allowing bankers to assume risks on behalf of their customers that they could not prudently assume otherwise.

II. LITERATURE REVIEW

II.1. Hedgers

Financial institutions have perhaps the greatest opportunity to hedge as compared to non-financial firms due to the nature of their assets and liabilities carrying interest-rate, default, currency, and liquidity risks to a larger extent. Of course these same positions may actually be speculation about the movement of a market rate or price since the bank also has more opportunity to have large positions in derivatives markets that appear to be hedging activity or market making, when in fact they are speculating.[1] Most nonfinancial firms are unable to use derivatives without scrutiny because they typically do not manage the same financial assets that banks do. It is because of the prevalence of banks in the derivative markets that they are good candidates to use when examining the effects of derivatives use and being a dealer on shareholder value and risk. One important difference is that banks have deposit insurance, thus there may be an incentive not to hedge since managers do not bear all of the downside risk as shown by Whidbee and Wohar (1999).

Diamond (1991) shows that financial intermediaries (FIs) have an incentive to manage risk because bankruptcy costs are reduced and charter values for the bank are preserved when the bank is hedged against large losses. As banks transfer risk to other institutions or investors that are better able to bear it, the value of the banking firm should rise if charter values matter and if a costly bankruptcy is avoided. Conversely, Gorton and Rosen (1995) discuss the lack of corporate control effectiveness would allow bad managers to [] find it optimal to take excessively risky actions (p. 1381). These two theories suggest competing hypotheses for bank manager derivatives use: that banks either hedge to maintain charter value, or do not hedge to increase risk due to the lack of effective corporate control and the deposit insurance subsidy.

Banks could also be using derivatives for reasons other than hedging. As noted by Allen and Santomero (1998), large banks have had substantial proportions of their earnings attributed to trading and market-making activity in these markets. Thus, there is a potential to increase bank shareholder wealth if failure probabilities are reduced while maintaining upside profit potential, or reducing risks while maintaining profit and cash-flow levels if shareholders value diversification at the firm level as in Stulz (1996). Further, if making a market in derivatives is a positive net present value project for the FI, this activity should increase shareholder wealth as well. On the other hand, if banks speculate and do not hedge, there could be a reduction in shareholder value if there is an expectation of losses in the market(s) where the FI has a substantial unhedged position.

Banks that hedge could increase shareholder value because the lower tail of the pricing distribution is truncated. Hedging for banks would be valuable if banks are better able to hedge than individual investors. This could be the case if banks develop expertise in hedging and derivatives markets through market making and trading for their own accounts as a dealer. If there is value in this market discovery, then banks should have this reflected in their equity prices to the extent that the market can discern this expertise and that a bank is hedging. To the extent that a bank is speculating and market participants are able to discern the probabilities that these positions could be harmful to the FI, shareholder value would decline on a relative basis. Bank hedging can also be value reducing or have no effect if deposit insurance protection provides risk-shifting opportunities.

Cyree and Huang (2005) research studies results indicate larger banks have a higher likelihood of using any of the hedging instruments. Higher proportions of insider holdings are positively related to the probability of using derivatives, which suggests insiders are concerned with protecting charter value and hedge because hedging is consistent with safety and soundness. Banks with lower capital tend to use derivatives, all else equal. Banks that have higher standard deviations of stock returns are more likely to use derivatives, suggesting that these either these banks are attempting to hedge risk, or that their derivatives usage is creating more market risk. Banks with higher on-balance sheet risk as measured by loans-to deposits, are more likely to use derivatives.

However, the overall conclusion is that derivatives use by banks has no gains in value for all groups except dealers, which supports findings by Guay and Kothari (2003), Hentschel and Kothari (2001), as well as bank hedging findings for accounting earnings by Brewer et al. (2001). One of the main research issues that have been intensively tackled is showing that dealers have lower value and higher risk as compared to non-users. Most results also indicate that prior positive results in this sense could be due to a lack of separating derivatives usage type and that researchers should be careful about grouping users together.

II.2. Prior Research Derivatives Usage

Prior work in derivatives usage for non-financial firms includes several theoretical papers to describe the potential benefits on firm value. Recently, there have been several papers that empirically investigate the effect of derivatives usage on firm value. We discuss the corporate (non-financial) literature first, and then the banking literature as it relates to derivatives use by banks.

II.2.1. Corporate Derivatives Research

Smith and Stulz (1985) indicate that managers of a firm might wish to hedge if their wealth is a concave function of firm value. This indicates that managers take into account the risk of wealth in a utility maximizing framework, and therefore hedging could be useful in reducing risk. Of course if the manager has a convex function for wealth relative to firm value, hedging could be detrimental since an unhedged firm would have greater value, albeit with higher risk. Firm manager payoffs are usually linear, except when there is option-based compensation in which case the relationship becomes more convex. Hence, Smith and Stulz (1985) indicate managers with options should hedge less than those without. Turfano (1996) finds support for these predictions empirically for gold mining firm managers. Likewise, Rogers, Simkins, and Carter (2004) find that airline firms add approximately 12 to 16 percent to firm value by hedging jet fuel costs.

Froot, Scharfstein, and Stein (1993) show that firms in distress are less likely to invest in positive NPV projects and therefore distress creates an underinvestment problem. For firms that use derivatives, the likelihood of distress is removed and these firms are better able to avoid the underinvestment problem, and by implication add value to the firm. There model predicts hedging is valuable through reducing the underinvestment problem.

Allayannis and Weston (2001) find that non-financial firms using currency derivatives have higher Tobins Q ratios than those that do not. Their results indicate that hedging for those firms with currency risk improves value by almost five percent. However, Guay and Kothari (2003) find that derivatives have moderate impact at best for non-financial firms. Similarly,

Hentschel and Kothari (2001) find non-financial firms have few, if any, differences in risk as measured by the standard deviation of daily stock returns.

While the firms are different in obvious ways, financial firms have a high probability of experiencing interest rate risk and thus an incentive to hedge this risk if they believe that hedging improves firm value or reduces risk. Additionally, banks often have substantial positions in foreign currency denominated loans, and have an incentive to hedge this risk

II.2.2. Bank Derivatives Research

Banks are unique in that they have largely financial assets that have interest rate, currency, default, and general economic risk. The risk inherent in these contracts can be sold to other market participants that are better able to manage these risks (see Diamond (1991)).

Additionally, as noted by Whidbee and Wohar (1999), the presence of deposit insurance for banks implies that a certain class of debtholders does not bear downside risk, and therefore the payoff to equity holders is even more convex than other industries. Sinkey and Carter (1999) find that banks that used derivatives had negative abnormal returns around the announcement of large losses by Bankers' Trust in 1994. The market reaction was negative for banks that were dealers as well as those banks that used derivatives. This indicates that market participants negatively view attempts to speculate by banks.

Brewer, Jackson, and Moser (2001) find banks that use interest rate derivatives in the 1986 to 1994 period do not have significantly different ROA or ROE. Their results indicate that there is little effect on accounting profits of derivatives use during this period; however they do find a difference at the ten-percent level in interest rate betas for interest rate hedgers vs. nonhedgers in one sub-period. This latter finding indicates weak support for derivatives enhancing firm value, although they do not explicitly test this hypothesis.

Carter and Sinkey (1998) study derivatives use by banks and find very few banks use derivatives in 1996, but for those that do, there is a positive relation to interest rate risk suggesting that these banks hedge. Whidbee and Wohar (1999) find banks with larger insider holdings (those greater than 10%) are associated with lower probabilities of derivatives use, suggesting close alignment of incentives with shareholders influences the risk management of the firm. These two studies focus on the rationale of derivatives use and bank characteristics of hedgers and non-hedgers.

II.2.3. Empirical Modeling

Recent studies have focused on banks use of derivatives and whether or not banks have differential shareholder value through derivatives use or the type of use. Their hypothesis is that banks do not have differential value due to using derivatives or the type of use. Banks may use derivatives to protect their charter value by limiting downside risk through hedging, or banks may not hedge which would increase risk and shareholder value because banks have limited downside risk due to deposit insurance. Banks may choose not to hedge, or to hedge less, when their risk exposure is lower and therefore the use of derivatives would lower firm value or have no effect. Banks are different than other firms in that their risk is more easily measured because they hold mostly financial assets and contingent contracts.

II.2.4. Summary and Conclusions of Prior Studies

Prior studies of non-financial firms find conflicting results about the choice to use derivatives and the impact of their use on firm value and risk. Most of these studies delete banking firms since they make markets in derivatives and/or are regulated. However, banking firms are also the most likely firms to use derivatives and their use has implications for the deposit insurance fund if banks are riskier and more likely to fail. Theory suggests that if firm managers have a concave wealth function, it may be beneficial to hedge, but if the wealth function is convex, it is not beneficial to hedge. Whidbee and Wohar (1999) show that bank manager wealth functions are more convex due to the presence of deposit insurance allowing for managers not bearing all of the downside risk.

In some recent papers, researchers empirically investigate the choice to use derivatives and the effects on bank firm value and risk. Banks choosing to hedge is consistent with protecting charter values as in Diamond (1991), and choosing not to hedge is consistent with excessive risk taking as in Gorton and Rosen (1995) due to a lack of effective corporate control. If hedging increases Tobins Q, this would support the findings of Allyannis and Weston (2001) who find currency hedging is valuable for nonfinancial firms. If, on the other hand, banks have no change or a decrease in value, there would be support for the findings of Guay and Kothari (2003) who find little benefit in hedging for nonfinancial firms.

Results indicate larger banks are more likely to use derivatives and higher proportions of insider holdings are positively related to the probability of using derivatives. Researchers hypothesize that insiders are more likely to be concerned with protecting charter value and hedge because hedging is consistent with safety and soundness as in Diamond (1991). This is expected to be true for closely-held banks, which are more likely to have higher ownership proportions.

In summary, there is evidence for gains due to derivatives use, which supports the nonfinancial firm findings of Allayannis and Weston (2001), when all derivatives use types are categorized together. However, when splitting the sample into usage type, there are no gains in value for banking firms using interest rate or both interest and currency derivatives, which supports findings by Guay and Kothari (2003), Hentschel and Kothari (2001), as well as bank hedging findings for accounting earnings by Brewer et al. (2001). Recent studies show that dealers have lower value and higher risk as compared to non-users in two-stage regressions, and this finding is robust to different definitions of insider holdings and censored regressions. Their results also indicate that prior results could be due to a lack of separating derivatives usage type and that researchers should be careful about grouping users together.

An important finding of the studies that also applies to this paper is that hedging does not destroy value on average (e.g., banks are not speculating and incurring large losses) if banks are not dealers. But in cross-sectional regressions of risk, banks in general do have higher stock return risk when using derivatives, and particularly so when they are dealers. The lack of negative results for firm value indicates that bank regulators and other stakeholders should continue to allow banks to use derivatives to hedge risk with close monitoring; however, these instruments do not apparently offer easy solutions to increase performance as indicated in some studies and shown by derivatives disasters throughout the history (also mentioned in this study).

III. THEORETICAL APPROACH

III.1. Financial Derivatives

Financial management of the multinational enterprise (MNE) in the 21^st century will need to consider the use of financial derivatives. These derivatives, so named because their values are derived from an underlying asset like a stock or a currency, are a powerful tool used in business today for two very distinct management objectives: speculation and hedging.

The financial manager of an MNE may purchase these financial derivatives in order to take positions in the expectation of profit, which is speculation, or may use these instruments to reduce the risks associated with the everyday management of corporate cash flow, which is hedging. Before these instruments can be used effectively, however, the financial manager must understand certain basics about their structure and pricing.

There are mainly three basic types of derivative instruments: options, futures and swaps. Interest rate swaps are the most widely used financial derivative instruments nowadays. Thus, their description, applicability and benefits will be given a special focus in the following sections.

III.1.1. Benefits of Derivatives

Derivatives are used by companies to achieve one or more of the following individual benefits :

Permit firms to achieve payoffs that they would not be able to achieve without derivatives, or could achieve only at greater costs.

Hedge risks that otherwise would not be possible to hedge.

Make underlying markets more efficient.

Reduce volatility of stock returns.

Minimize earnings volatility.

Reduce tax liabilities.

Motivate management (agency theory effect).

We need to underline the fact that financial derivatives are a powerful tool in the hands of careful and competent financial managers. They can also be very destructive devices when used recklessly. The 1990s were littered with cases in which financial managers lost control of their derivatives, resulting in significant losses for their companies and occasionally outright collapse. In the right hands and with proper controls, however, financial derivatives can provide management with opportunities to enhance and protect their corporate financial performance.

III.2. Currency and Interest Rate Swaps

Swap, as derivative security, has altered the way many financial executives think about issuing and managing company debt. Moreover, swaps are increasingly used by banks to hedge both their clients and their own exposure to both currency and interest rate fluctuations in the markets they are linked to through their operations, assets and liabilities.

In finance, a swap is a derivative in which two counterparties agree to exchange one stream of cash flows against another stream. These streams are called the legs of the swap.

The cash flows are calculated over a notional principal amount, which is usually not exchanged between counterparties. Consequently, swaps can be used to create unfunded exposures to an underlying asset, since counterparties can earn the profit or loss from movements in price without having to post the notional amount in cash or collateral.

As derivative instruments, swaps can be used to hedge certain risks such as interest rate risk, or currency exposure, or to speculate on changes in the underlying prices.

A swap is piece of paper documenting the trade of future cash flows between two parties in which each commits to pay or to receive the others cash flows. The market value of a swap at any time equals the difference in the value of the underlying cash flows exchanged. A currency swap involves the trade of liabilities denominated in different currencies, while an interest rate swap entails the trade of fixed-rate payments for floating-rate ones. Swaps do not appear on the participating companies financial statements, and the lenders typically are unaware a swap has occurred. Swaps have become so commonplace that an active market now exists in which standard swaps are bought and sold over the phone much like stocks and bonds. If your company has a 10-year, Swiss franc liability and would prefer one denominated in U.S. dollars, phone a swap dealer for a quote.

Swaps inevitably seem exotic and a bit pathological on first acquaintance, but the underlying concept is really an elementary one: whenever each of two parties has something that the other wants, a trade can benefit both. A swap is such a trade in which the items exchanged are future interest and principal payments. Some swaps, denoted as asset swaps, involve rights to receive future payments, while more common liability swaps involve the obligation to make future payments.

Swaps have proven to be valuable financing tools for at least two reasons. First, swaps help solve a fundamental problem facing many companies when raising capital. Prior to the advent of swaps, a companys decision about what type of debt to issue often involved a compromise between what the company really wanted and what investors were willing to buy. An issuer might have wanted fixed-rate, French franc debt but settled for floating-rate, Canadian dollar debt because the terms were better. But with swaps, the issuer can have his cake and eat it too. Just issue floating-rate, Canadian dollar debt and immediately swap into fixed-rate, French franc debt. In effect, swaps enable the issuer to separate concerns about what type of debt the company needs from those regarding what type investors want to buy, thereby greatly simplifying the issuance decision and reducing borrowing costs.

A second virtue of swaps is that they are a slick tool for interest rate and currency risk management. Worried the Swiss franc will soon strengthen, increasing the dollar burden of your companys Swiss franc debt? No problem: swap out of francs into dollars. Worried that interest rates are about to fall, saddling your company with a pile of high-cost, fixed-rate debt? Piece of cake: swap into floating-rate debt and watch borrowing costs float down with the rates.

III.3. Hedging Defined

III.3.1. Origins

The term is derived from the phrase 'hedging your bets' used in gambling games such as roulette. The hedges on a roulette table are the lines between numbers or number groups. Placing a hedged bet is one where the chips lie across one or more hedges (i.e. on a line between two numbers or on a corner between three or four numbers). The bet then covers all the numbers involved at an appropriately reduced stake (e.g. 1/2, 1/3, 1/4).

III.3.2. Definition

In finance, a hedge is an investment that is taken out specifically to reduce or cancel out the risk in another investment. Hedging is a strategy designed to minimize exposure to an unwanted business risk, while still allowing the business to profit from an investment activity.

Typically, a hedger might invest in a security that he believes is under-priced relative to its 'fair value' (for example a mortgage loan that he is then making), and combine this with a short sale of a related security or securities. Thus the hedger is indifferent to the movements of the market as a whole, and is interested only in the performance of the 'under-priced' security relative to the hedge. Holbrook Working, a pioneer in hedging theory, called this strategy 'speculation in the basis,' where the basis is the difference between the hedge's theoretical value and its actual value (or between spot and futures prices in Working's time).

Some form of risk taking is inherent to any business activity. Some risks are considered to be 'natural' to specific businesses, such as the risk of oil prices increasing or decreasing is natural to oil drilling and refining firms. Other forms of risk are not wanted, but cannot be avoided without hedging. Someone who has a shop, for example, expects to face natural risks such as the risk of competition, of poor or unpopular products, and so on. The risk of the shopkeeper's inventory being destroyed by fire is unwanted, however, and can be hedged via a fire insurance contract. Not all hedges are financial instruments: a producer that exports to another country, for example, may hedge its currency risk when selling by linking its expenses to the desired currency. Banks and other financial institutions use hedging to control their asset-liability mismatches, such as the maturity matches between long, fixed-rate loans and short-term (implicitly variable-rate) deposits.

III.3.3. Categories of Hedgeable Risk

Interest rate risk is the risk that the relative value of an interest-bearing asset, such as a loan or a bond, will worsen due to an interest rate increase. Interest rate risks can be hedged using fixed income instruments or interest rate swaps.

Equity is the risk that the value of the equity falls. This is mainly applicable to economic agents whose assets are equity holdings

Futures contracts and forward contracts are a means of hedging against the risk of adverse market movements. These originally developed out of commodity markets in the nineteenth century, but over the last fifty years a huge global market developed in products to hedge financial market risk. Those products are called generically derivatives.

III.3.4. Hedging Currency Risk

Currency hedging (also known as Foreign Exchange Risk hedging) is used both by financial investors to parse out the risks they encounter when investing abroad, as well as by non-financial actors in the global economy for whom multi-currency activities are a necessary evil rather than a desired state of exposure.

For example, labor costs are such that much of the simple commoditized manufacturing in the global economy today goes on in China and South-East Asia (Philippines, Vietnam, Indonesia, etc.). The cost benefit of moving manufacturing to outsource providers outweighs the uncertainties of doing business in foreign countries, so many businesses are moving manufacturing operations overseas. But the benefits of doing this have to be weighted also against currency risk.

If the cost of manufacturing goods in another country is denominated in a currency other than the one that the finished goods will be sold for, there is the risk that changes in the values of each currency will reduce profit or produce a loss. Currency hedging is akin to insurance that limits the impact of foreign exchange risk.

Currency hedging is not always available, but is readily found at least in the major currencies of the world economy, the growing list of which qualify as major liquid markets beginning with the 'Major Eight' (USD, GBP, EUR, JPY, CHF, HKD, AUD, CAD), which are also called the 'Benchmark Currencies', and expands to include several others by virtue of liquidity.

Currency hedging, like many other forms of financial hedging, can be done in two primary ways: with standardized contracts, or with customized contracts (also known as over-the-counter or OTC).

The financial investor may be a hedge fund that decides to invest in a company in, for example, Brazil, but does not want to necessarily invest in the Brazilian currency. The hedge fund can separate out the credit risk (i.e. the risk of the company defaulting), from the currency risk of the Brazilian Real by 'hedging' out the currency risk. In effect, this means that the investment is effectively a USD investment, in Brazil. Hedging allows the investor to transfer the currency risk to someone else, who wants to take up a position in the currency. The hedge fund has to pay this other investor to take on the currency exposure, similar to insuring against other types of events.

As with other types of financial products, hedging may allow economic activity to take place, that would otherwise not have been possible (as a loan, for example, may allow an individual to purchase a home that would be 'too expensive' if the individual had to pay cash). The increased investment is assumed in this way to raise economic efficiency.

III.4. Hedging Interest Rate Risk Exposure through SWAPS

Interest rate swaps are contractual commitments between a firm and a swap dealer (e.g. a bank) and are completely independent of the interest rate exposure of a firm. That is, the firm may enter into a swap for any reason it sees fit and then swap a notional principal that is less than, equal to, or even greater than the total position being managed. For example, a firm with a variety of floating-rate loans on its books may enter into interest rate swaps for only 70% of the existing principal (its exposure), if it wishes. The reason for entering into a swap, and the swap position of the firm enters into, is purely at managements discretion (please refer to the below table: Interest Rate SWAP Strategies). It should also be noted that the interest rate swap market is filling a gap in market efficiency. If all firms had free and equal access to capital markets, regardless of interest rate structure or currency of denomination, the swap market would most likely not exist. The fact that the swap market not only exists but flourishes and provides benefits to all parties is in some ways the proverbial free lunch, due to comparative advantage.

Table 1: Interest Rate SWAP Strategies

III.4.1. Structure

In an interest rate swap, each counterparty agrees to pay either a fixed or floating rate denominated in a particular currency to the other counterparty. The fixed or floating rate is multiplied by a notional principal amount (say, USD 1 million). This notional amount is generally not exchanged between counterparties, but is used only for calculating the size of cash flows to be exchanged.

The most common interest rate swap is one where one counterparty pays a fixed rate (the swap rate) while receiving a floating rate (usually pegged to LIBOR). Consider the following swap in which Party A agrees to pay Party B periodic interest rate payments of LIBOR + 50 bps (0.50%) in exchange for periodic interest rate payments of 3.00%. Note that there is no exchange of the principal amounts and that the interest rates are on a 'notional' (i.e. imaginary) principal amount. Also note that the interest payments are settled in net (e.g. if LIBOR + 50 bps is 1.20% then Party A receives 1.80% and Party B pays 1.80%). The fixed rate (3.00% in this example) is referred to as the swap rate.

At the point of initiation of the swap, the swap is priced so that it has a net present value of zero. If one party wants to pay 50 bps above the par swap rate, the other party has to pay approximately 50 bps over LIBOR to compensate for this.

Being OTC instruments interest rate swaps can come in a huge number of varieties and can be structured to meet the specific needs of the counterparties. That said, by far the most common are fixed-for-fixed, fixed-for-floating or floating-for-floating. The legs of the swap can be in the same currency or in different currencies. (A single-currency fixed-for-fixed rate swap is generally not possible; since the entire cash-flow stream can be predicted at the outset there would be no reason to maintain a swap contract as the two parties could just settle for the difference between the present values of the two fixed streams, the only exceptions would be where the notional amount on one leg is uncertain or other esoteric uncertainty is introduced)

III.4.2. Types of Interest Rate Swaps

Fixed-for-floating rate swap, same currency

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency A indexed to X on a notional N for a tenor T years. For example, you pay fixed 5.32% monthly to receive USD 1M Libor monthly on a notional USD 1 million for 3 years. The party that pays fixed and receives floating coupon rates is said to be long the interest swap.

Fixed-for-floating swaps in same currency are used to convert a fixed rate asset/liability to a floating rate asset/liability or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of USD 10 million that returns USD 1M Libor +25 bps monthly, it may enter into a fixed-for-floating swap. In this swap, the company would pay a floating USD 1M Libor+25 bps and receive a 5.5% fixed rate, locking in 20bps profit.

Fixed-for-floating rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay floating rate in currency B indexed to X on a notional N at an initial exchange rate of FX for a tenure of T years. For example, you pay fixed 5.32% on the USD notional 10 million quarterly to receive JPY 3M (JIBOR) monthly on a JPY notional 1.2 billion (at an initial exchange rate of USDJPY 120) for 3 years. For nondeliverable swaps, the USD equivalent of JPY interest will be paid/received (according to the FX rate on the FX fixing date for the interest payment day). No initial exchange of the notional amount occurs unless the Fx fixing date and the swap start date fall in the future.

Fixed-for-floating swaps in different currencies are used to convert a fixed rate asset/liability in one currency to a floating rate asset/liability in a different currency, or vice versa. For example, if a company has a fixed rate USD 10 million loan at 5.3% paid monthly and a floating rate investment of JPY 1.2 billion that returns JPY 1M Libor +50 bps monthly, and wants to lock in the profit in USD as they expect the JPY 1M Libor to go down or USDJPY to go up (JPY depreciate against USD), then they may enter into a Fixed-Floating swap in different currency where the company pays floating JPY 1M Libor+50 bps and receives 5.6% fixed rate, locking in 30bps profit against the interest rate movement and the foreign exchange exposure.

Floating-for-floating rate swap, same currency

Party P pays/receives floating interest in currency A Indexed to X to receive/pay floating rate in currency A indexed to Y on a notional N for a tenor T years. For example, you pay JPY 1M Libor monthly to receive JPY 1M Tibor monthly on a notional JPY 1 billion for 3 years.

Floating-for-floating rate swaps are used to hedge against or speculate on the spread between the two indexes widening or narrowing. For example, if a company has a floating rate loan at JPY 1M Libor and the company has an investment that returns JPY 1M Tibor+30 bps and currently the JPY 1M Tibor = JPY 1M Libor +10bps. At the moment, this company has a net profit of 40 bps. If the company thinks JPY 1M tibor is going to come down or JPY 1M Libor is going to increase in the future and wants to insulate from this risk, they can enter into a Float float swap in same currency where they pay JPY TIBOR +10 bps and receive JPY LIBOR+35 bps. with this, they have effectively locked in a 15 bps profit instead of running with a current 40 bps gain and index risk. The 5bps difference comes from the swap cost which includes the market expectations of the future rates in these two indices and the bid/offer spread which is the swap commission for the swap dealer.

Floating-for-floating rate swaps are also seen where both sides reference the same index, but on different payment dates, or use different business day conventions. These have almost no use for speculation, but can be vital for asset-liability management. An example would be swapping 3M Libor being paid with prior non-business day convention, quarterly on JAJO (i.e. Jan, Apr, Jul, Oct) 30, into FMAN (i.e. Feb, May, Aug, Nov) 28 modified following.

Floating-for-floating rate swap, different currencies

Party P pays/receives floating interest in currency A indexed to X to receive/pay floating rate in currency B indexed to Y on a notional N at an initial exchange rate of FX for a tenor T years. For example, you pay floating USD 1M Libor on the USD notional 10 million quarterly to receive JPY 3M Tibor monthly on a JPY notional 1.2 billion (at an initial exchange rate of USDJPY 120) for 4 years.

To explain the use of this type of swap, consider a US company operating in Japan. To fund their Japanese growth, they need JPY 10 billion. The easiest option for the company is to issue debt in Japan. As the company might be new in the Japanese market without a well known reputation among the Japanese investors, this can be an expensive option. Added on top of this, the company might not have appropriate debt issuance program in Japan and they might lack sophisticated treasury operation in Japan. To overcome the above problems, it can issue USD debt and convert to JPY in the FX market. Although this option solves the first problem, it introduces two new risks to the company:

FX risk. If this USDJPY spot goes up at the maturity of the debt, then when the company converts the JPY to USD to pay back its matured debt, it receives less USD and suffers a loss.

USD and JPY interest rate risk If the JPY rates come down, the return on the investment in Japan might go down and this introduces an interest rate risk component.

The first exposure in the above can be hedged using long dated FX forward contracts but this introduces a new risk where the implied rate from the FX spot and the FX forward is a fixed rate but the JPY investment returns a floating rate. Although there are several alternatives to hedge both the exposures effectively without introducing new risks, the easiest and the most cost effective alternative would be to use a floating-for-floating swap in different currencies. In this, the company raises USD by issuing USD Debt and swaps it to JPY. It receives USD floating rate (so matching the interest payments on the USD Debt) and pays JPY floating rate matching the returns on the JPY investment.

Fixed-for-fixed rate swap, different currencies

Party P pays/receives fixed interest in currency A to receive/pay fixed rate in currency B for a term of T years. For example, you pay JPY 1.6% on a JPY notional of 1.2 billion and receive USD 5.36% on the USD equivalent notional of 10 million at an initial exchange rate of USDJPY 120.

Other variations

A number of other variations are possible, although far less common. Mostly tweaks are made to ensure that a bond is hedge 'perfectly', so that all the interest payments received are exactly offset by the swap. This can lead to swaps where principal is paid on one or more legs, rather than just interest (for example to hedge a coupon strip), or where the balance of the swap is automatically adjusted to match that of a prepaying bond (such as RMBS).

III.4.3. Uses of Interest Rate Swaps

Interest rate swaps were originally created to allow multi-national companies to evade exchange controls. Today, interest rate swaps are used to hedge against or speculate on changes in interest rates.

Hedging

Today, interest rate swaps are often used by firms to alter their exposure to interest-rate fluctuations, by swapping fixed-rate obligations for floating rate obligations, or vice versa. By swapping interest rates, a firm is able to alter its interest rate exposures and bring them in line with management's appetite for interest rate risk. For example, Fannie Mae uses interest rate derivatives to hedge its cash flows. The products it uses are pay-fixed swaps, receive-fixed swaps, basis swaps, interest rate cap and swaptions, and forward starting swaps. Its 'cash flow hedges' had a notional value of $872 billion at December 31, 2003, while its 'fair value hedges' stood at $169 billion (SEC Filings) (2003 10-K page 79). Its 'net value' on 'a net present value basis, to settle at current market rates all outstanding derivative contracts' was (7,712) million and 8,139 million, which makes a total of 6,633 million when a 'purchased options time value' of 8,139 million is added.

Speculation

Interest rate swaps are also used speculatively by hedge funds or other investors who expect a change in interest rates or the relationships between them. Traditionally, fixed income investors who expected rates to fall would purchase cash bonds, whose value increased as rates fell. Today, investors with a similar view could enter a floating-for-fixed interest rate swap; as rates fall, investors would pay a lower floating rate in exchange for the same fixed rate.

Interest rate swaps are also very popular due to the arbitrage opportunities they provide. Due to varying levels of creditworthiness in companies, there is often a positive quality spread differential which allows both parties to benefit from an interest rate swap. The interest rate swap market is closely linked to the Eurodollar futures market which trades at the Chicago Mercantile Exchange in United States.

III.4.4. Valuation and Pricing of Interest Rate Swaps

The present value of a plain vanilla (i.e. fixed rate for floating rate) swap can easily be computed using standard methods of determining the present value (PV) of the fixed leg and the floating leg.

The value of the fixed leg is given by the present value of the fixed coupon payments known at the start of the swap, i.e.

where C is the swap rate, M is the number of fixed payments, P is the notional amount, t_i is the number of days in period i, T_i is the basis according to the day count convention and df_i is the discount factor.

Similarly, the value of the floating leg is given by the present value of the floating coupon payments determined at the agreed dates of each payment. However, at the start of the swap, only the actual payment rates of the fixed leg are known in the future, whereas the forward rates (derived from the yield curve) are used to approximate the floating rates. Each variable rate payment is calculated based on the forward rate for each respective payment date. Using these interest rates leads to a series of cash flows. Each cash flow is discounted by the zero-coupon rate for the date of the payment; this is also sourced from the yield curve data available from the market. Zero-coupon rates are used because these rates are for bonds which pay only one cash flow. The interest rate swap is therefore treated like a series of zero-coupon bonds. Thus, the value of the floating leg is given by the following:

where N is the number of floating payments, f_j is the forward rate, P is the notional amount, t_j is the number of days in period j, T_j is the basis according to the day count convention and df_j is the discount factor.The discount factor always starts with 1. The discount factor is found as follows: [Discount factor in the previous period]/[1+(Forward rate of the floating underlying asset in the previous period X Number of days in period/360)].

The fixed rate offered in the swap is the rate which values the fixed rates payments at the same PV as the variable rate payments using today's forward rates, i.e.:

Therefore, at the time the contract is entered into, there is no advantage to either party, i.e.,

Thus, the swap requires no upfront payment from either party.

During the life of the swap, the same valuation technique is used, but since, over time, the forward rates change, the PV of the variable-rate part of the swap will deviate from the unchangeable fixed-rate side of the swap. Therefore, the swap will be an asset to one party and a liability to the other. The way these changes in value are reported is the subject of IAS 39 for jurisdictions following IFRS, and FAS 133 for U.S. GAAP. Swaps are marked to market by debt security traders to visualize their inventory at a certain time.

III.4.5. Risks

Interest rate swaps expose users to interest rate risk and credit risk.

• Interest rate risk originates from changes in the floating rate. In a plain vanilla fixed-for-floating swap, the party who pays the floating rate benefits when rates fall. (Note that the party that pays floating has an interest rate exposure analogous to a long bond position.)

• Credit risk on the swap comes into play if the swap is in the money or not. If one of the parties is in the money, then that party faces credit risk of possible default by another party. This is true for all swaps where there is no exchange of principal.

The swap agreement does not replace the existing loan agreement, it supplements it.

III.4.6. Market size

The Bank for International Settlements reports that interest rate swaps are the largest component of the global OTC derivative market. The notional amount outstanding as of December 2006 in OTC interest rate swaps was $229.8 trillion, up $60.7 trillion (35.9%) from December 2005. These contracts account for 55.4% of the entire $415 trillion OTC derivative market. However, interest rate swaps are not standardized enough to allow them to be traded through a futures exchange like an option or a futures contract.

III.4.7. Benefits of the IRS

As interest rates continue to rise, banks are looking at hedging their bets through derivatives. The instruments typically allow banks to buy a guarantee that a portion of their portfolio is linked to the interest-rate market.

Banks that want to hedge their loan portfolio typically seek out a large institution such as a Wall Street financier or a multi-national bank that is willing to guarantee additional interest payments if rates rise. In return, the bank seeking the hedge will pay a fixed percentage of the interest on the loan.

The hedging of interest rates has traditionally been the domain of major banks but with the Federal Reserve pushing interest rates higher, and lower hedging minimums, have led smaller banks to use a similar strategy.

A recent study by the University of Michigan's Ross School of Business analyzed data from 8,000 commercial banks from 1997 to 2003 and found that about 400 of those banks used hedging at the end of 2003.

It has been proven that when rates change a lot, or go up a lot, banks that are using derivatives show less change in their business than banks that aren't using it.

The last three years has shown a $43.3 trillion increase in the notional amount of derivative, or the value of the assets underlying the hedges, according to Federal Deposit Insurance Corporation reports. As of September, $99.6 trillion in assets were being used for hedging, compared to $56.3 trillion in December of 2002.

Large banks, including Well Fargo and Bank of America, commonly use derivative hedging.

However, using derivatives to hedge is not very simple and easy to apply, and the practice especially for banks that trade intensively in derivative markets is not without hazards. As demonstrated by the large derivative disasters occurred due to some misunderstandings of the use and characteristics of hedging products by some traders, unless you have a system in place and the technical expertise needed, there is much scope to end up increasing overall risk exposure instead of hedging it.

IV. CORPORATE USE OF DERIVATIVES FOR HEDGING

If we are considering a stock investment and we read that the company uses derivatives to hedge some risk, should we be concerned or reassured? Warren Buffett's stand is famous: he has attacked all derivatives, saying he and his company 'view them as time bombs, both for the parties that deal in them and the economic system' (2003 Berkshire Hathaway Annual Report). On the other hand, the trading volume of derivatives has escalated rapidly, and non-financial companies continue to purchase and trade them in ever-greater numbers. Consider the Chicago Mercantile Exchange, which is the largest exchange for futures contracts in the United States. As of November 2004, the average daily volume of futures contracts reached 3.2 million, up a stunning 40% from the previous year. In the same month, foreign-exchange futures set a new record for single-day volume, reaching more than half-a-million contracts, with a notional value of over $72 billion.

We have seen in our analysis that derivatives can equally benefit both financial institutions and corporations that know how to use them in the sense of hedging their overall risk exposure to market fluctuations.

To help on evaluating a company's use of derivatives for hedging risk, we'll look at the three most common ways to use derivatives for hedging.

IV.1. Foreign-Exchange Hedge

One of the more common corporate uses of derivatives is for hedging foreign-currency risk, or foreign-exchange risk, which is the risk that a change in currency exchange rates adversely impacts business results.

Let's consider an example of foreign-currency risk with ACME Corporation, a hypothetical U.S.-based company that sells widgets in Germany. During the year, ACME Corp sells 100 widgets, each priced at 10 euros. Therefore, our constant assumption is that ACME sells 1,000 euros worth of widgets:

When the dollar-per-euro exchange rate increases from $1.33 to $1.50 to $1.75, it takes more dollars to buy one euro, or one euro translates into more dollars, meaning the dollar is depreciating or weakening. As the dollar depreciates, the same number of widgets sold translates into greater sales in dollar terms. This demonstrates how a weakening dollar is not all bad: it can boost export sales of U.S. companies. (Alternatively, ACME could reduce its prices abroad, which, because of the depreciating dollar, would not hurt dollar sales; this is another approach available to a U.S. exporter when the dollar is depreciating.) 

The above example illustrates the 'good news' event that can occur when the dollar depreciates, but a 'bad news' event happens if the dollar appreciates and export sales end up being less. In the above example, we made a couple of very important simplifying assumptions that affect whether the dollar depreciation is a good or bad event:

(1)   We assumed that ACME Corp manufactures its product in the U.S. and therefore incurs its inventory or production costs in dollars. If instead ACME manufactured its German widgets in Germany, production costs would be incurred in euros. So even if dollar sales increase due to depreciation in the dollar, production costs would go up too! This effect on both sales and costs is called a natural hedge: the economics of the business provide their own hedge mechanism. In such a case, the higher export sales (resulting when the euro is translated into dollars) are likely to be mitigated by higher production costs.

(2)   We also assumed that all other things are equal, and often they are not. For example, we ignored any secondary effects of inflation and whether ACME can adjust its prices.

Even after natural hedges and secondary effects, most multinational corporations are exposed to some form of foreign-currency risk.

Now let's illustrate a simple hedge that a company like ACME might use. To minimize the effects of any USD/EUR exchange rates, ACME purchases 800 foreign-exchange futures contracts against the USD/EUR exchange rate. The value of the futures contracts will not, in practice, correspond exactly on a 1:1 basis with a change in the current exchange rate (that is, the futures rate won't change exactly with the spot rate), but we will assume it does anyway. Each futures contract has a value equal to the 'gain' above the $1.33 USD/EUR rate. (Only because ACME took this side of the futures position, somebody - the counter-party - will take the opposite position):

In this example, the futures contract is a separate transaction; but it is designed to have an inverse relationship with the currency exchange impact, so it is a decent hedge. Of course, it's not a free lunch: if the dollar were to weaken instead, then the increased export sales are mitigated (partially offset) by losses on the futures contracts.

IV.2. Interest-Rate Hedge

Companies can hedge interest-rate risk in various ways. Consider a company that expects to sell a division in one year and at that time to receive a cash windfall that it wants to 'park' in a good risk-free investment. If the company strongly believes that interest rates will drop between now and then, it could purchase (or 'take a long position on') a treasury futures contract. The company is effectively locking in the future interest rate.

Here is a different example of a perfect interest-rate hedge used by Johnson Controls, as noted in its 2004 annual report:

Fair Value Hedges - The Company [JCI] had two interest rate swaps outstanding at September 30, 2004 designated as a hedge of the fair value of a portion of fixed-rate bondsThe change in fair value of the swaps exactly offsets the change in fair value of the hedged debt, with no net impact on earnings.  (JCI 10K, 11/30/04 Notes to Financial Statements)  .

Johnson Controls is using an interest rate swap. Before it entered into the swap, it was paying a variable interest rate on some of its bonds. (For example, a common arrangement would be to pay LIBOR plus margin and to reset the rate every six months). We can illustrate these variable rate payments with a down-bar chart:  

Now let's look at the impact of the swap, illustrated below. The swap requires JCI to pay a fixed rate of interest while receiving floating-rate payments. The received floating-rate payments (shown in the upper half of the chart below) are used to pay the pre-existing floating-rate debt.

JCI is then left only with the floating-rate debt, and has therefore managed to convert a variable-rate obligation into a fixed-rate obligation with the addition of a derivative. And again, note the annual report implies JCI has a 'perfect hedge': The variable-rate coupons that JCI received exactly compensates for the company's variable-rate obligations.

IV.3. Commodity or Product Input Hedge

Companies that depend heavily on raw-material inputs or commodities are sensitive, sometimes significantly, to the price change of the inputs. Airlines, for example, consume lots of jet fuel. Historically, most airlines have given a great deal of consideration to hedging against crude-oil price increases - although at the start of 2004 one major airline mistakenly settled (eliminating) all of its crude-oil hedges: a costly decision ahead of the surge in oil prices.

Monsanto (ticker: MON) produces agricultural products, herbicides and biotech-related products. It uses futures contracts to hedge against the price increase of soybean and corn inventory:

Changes in Commodity Prices: Monsanto uses futures contracts to protect itself against commodity price increases [] these contracts hedge the committed or future purchases of, and the carrying value of payables to growers for soybean and corn inventories. A 10 percent decrease in the prices would have a negative effect on the fair value of those futures of $10 million for soybeans and $5 million for corn. We also use natural-gas swaps to manage energy input costs. A 10 percent decrease in price of gas would have a negative effect on the fair value of the swaps of $1 million. (Monsanto 10K, 11/04/04 Notes to Financial Statements) .

IV.4. Conclusions to Corporate Use of Hedging

We have reviewed three of the most popular types of corporate hedging with derivatives. There are many other derivative uses, and new types are being invented. For example, companies can hedge their weather risk to compensate them for extra cost of an unexpectedly hot or cold season. The derivatives we have reviewed are not generally speculative for the company. They help to protect the company from unanticipated events: adverse foreign-exchange or interest-rate movements and unexpected increases in input costs. The investor on the other side of the derivative transaction is the speculator. However, in no case are these derivatives free. Even if, for example, the company is surprised with a good-news event like a favorable interest-rate move, the company (because it had to pay for the derivatives) receives less on a net basis than it would have without the hedge.

As far as hedging agents, like banks or hedge funds, are concerned, if they use derivatives to hedge their clients exposures, they should always win.

V. COMPARATIVE ADVANTAGE AND STRUCTURING A SWAP AGREEMENT

V.1. Comparative Advantage of the Parties Involved

Companies of different credit quality are treated differently by the capital markets. This differentiation gives scope to swap agreements for better access to capital (cheaper debt).

As illustrative example of how comparative advantage leads to swap agreements and how it is actually structured, we take two companies, Unilever (U.K.) and Xerox (U.S.), which are both in the market for $30 million of debt for a five-year period.

Unilever has a AAA credit rating (the highest) and therefore has access to both fixed and floating-rate interest debt at attractive rates. Unilever would prefer to borrow at floating rates, as it already has fixed-rate funds and wishes to increase the proportion of its debt portfolio that is floating.

Xerox has a BBB credit rating (the lowest major category of investment-grade debt ratings) and would prefer to raise the debt at fixed rates of interest. Although Xerox has access to both fixed and floating-rate funds, the fixed rate debt is considered expensive as offered to it.

The firms, through Citibank, could actually borrow in their relatively advantaged markets and then swap their debt service payments, as pictured below:

   

Citibank

Rates available to Unilever  Rates available to Xerox

Borrow fixed: 7.000% Borrow fixed: 8.000%

Borrow floating: LIBOR+ % Borrow floating: LIBOR+ %

V.2. Implementation of the Interest Rate Swap Agreement

Each company first borrows in the market in which it has relative comparative advantage. As illustrated in the above picture, Unilever can borrow fixed-rate funds 1.000% cheaper than Xerox (7.000% as opposed to 8.000%), and can borrow floating-rate funds % cheaper ( % relative to Xeroxs %). This means that Unilevers relative comparative advantage is to borrow fixed-rate funds, and therefore Xerox should borrow floating-rate funds.

The sequence of financial operations that would benefit both companies by entering into a swap agreement (as legs) is detailed below:

1. Unilever borrows at the fixed of 7.000% per annum, and then enters into a receive fixed/pay floating interest rate swap with Citibank. The bank then agrees to make the debt service payments at 7.000% on behalf of Unilever for the life of the swap agreement (five years).
2. Unilever agrees in turn to pay Citibank a floating rate of interest, one-year LIBOR, enabling it to make debt service payments on a floating-rate basis, which it prefers. The interest rate it negotiates with Citibank is lower than the rate it could have acquired on its own.
3. Xerox borrows at the floating rate of LIBOR + %, and then swaps the payments with Citibank. Citibank agrees to service the floating-rate debt payments on behalf of Xerox.
4. Xerox agrees in turn to pay Citibank a fixed rate of interest, 7.875%, enabling Xerox to make fixed-rate debt service payments which it prefers but at lower cost of funds than it could have acquired on its own.

V.3. Benefits of the Interest Rate Swap Example

Unilever borrowed funds at 7.000% fixed rate. It has now entered into a swap agreement in which it will swap fixed for floating, LIBOR + 0%, in return for Citibank making its 7.000% interest payments on its debt. Unilever then has the following combined interest payments:

Unilever borrows at fixed rates: (7.000%)

Swaps fixed for floating rates:  +7.000% Receives fixed

(LIBOR) Pays floating

Net interest (debt + swap)  (LIBOR)

Xerox borrowed funds at LIBOR + %, a floating rate of interest. It has now entered into a swap agreement to swap floating for fixed, meaning that it will receive a floating rate of LIBOR + % and pay a fixed rate of interest, 7.875%. The combined interest payments of Xerox are:

Xerox borrows at floating rates: (LIBOR+ %)

Swaps floating for fixed rates: + LIBOR + % Receives floating

(7.875%) Pays fixed

Net interest (debt + swap)  (7.875%)

Each of the borrowers benefits from the interest rate swap by being able to borrow capital in the preferred interest rate structure and at a lower rate than obtainable on their own.

Unilever (U.K.) Xerox (U.S.)

If borrowing directly  LIBOR+ % 8.000%

If borrowing through swap  LIBOR+ 0% 7.875%

Savings: + % +.125%

How is this exchange possible? Each benefits as a result of the specialization of each borrower acquiring funds in their market of preferred access, and then exchanging interest payment streams, redistributing the benefits of specialization.

However, pitfalls do exist. Even sophisticated financial executives can misunderstand the risks involved in more complex interest rate swaps. [7] Some examples of how misuse and misinterpretation of derivatives can lead to financial disasters are detailed in the following section.

VI. PRUDENCE IN PRACTICE

Major corporate financial disasters related to financial derivatives continue to be a problem in global business. As is the case with so many issues in modern society, technology is not at fault; rather, it is human error in use of technology.

Since the early 1970s, derivatives have increasingly been used by firms to manage their exposure to risks. When a derivative is purchased, only part of the value of the underlying asset is at risk, while the opportunity to benefit from favourable price fluctuations is retained. Derivatives can offer potentially enormous gains, which can lead to their use as speculative instruments. They also offer potentially debilitating losses, depending on the positions taken.

After reviewing some of the most important disasters from derivatives misuse (Please refer to table 2 below), we conclude our discussion of financial derivatives with a note of caution and humility from an essay in the Harvard Business Review by Peter Bernstein:

More than any other development, the quantification of risk defines the boundary between modern times and the rest of the history. The speed, power, movement, and instant communication that characterize our age would have been inconceivable before science replaced superstition as a bulwark against risks of all kinds.

It is hubris that we believe that we can put reliable and stable numbers on the impact of a politicians power, on the probability of a takeover boom like the one that occurred in the 1980s, on the return on the stock market over the next 2, 20 or 50 years, or on subjective factors like utility and risk aversion. It is equally silly to limit our deliberations only to those variables that do lend themselves to quantifications, excluding all serious consideration of the unquantifiable. It is irrational to confuse probability with timing and to assume that an event with low probability is therefore not imminent. Such confusion, however, is by no means unusual. And it surely is naive to define discontinuity as anomaly instead of as normality; only the shape and the timing of the disturbances are hidden from us, not their inevitability.

Finally, the science of risk management is capable of creating new risks even as it brings old risks under control. Our faith in risk management encourages us to take risks we otherwise would not take. On most counts, that is beneficial. But we should be wary of increasing the total amount of risk in the system. Research shows that the security of seat belts encourages drivers to behave more aggressively, with the result that the number of accidents rises even as the seriousness of injury in any one accident may diminish. (Excerpt from The New Religion of Risk Management by Peter L. Bernstein, March-April 1996)

Table 2: A selective list of derivative and managerial disasters:

VII. CONCLUSIONS

Derivatives development and increasing volatility in financial markets have raised hedging opportunities for economic agents. Both financial and non-financial institutions benefit from increasing hedging opportunities and access to hedging instruments in their risk management strategies.

As studies have shown, hedging is both a result of risk management strategies implemented by companies and a strategy in itself as it has been proven that intermediaries, such as banks and hedge funds, in their acting as derivatives dealers, need to hedge both for their clients and for their own to reduce risk exposure to market volatility.

Practice had demonstrated through the history that derivative instruments misuse and lack of experience can increase risk exposure rather than reducing it, leading to financial disasters.

Whether hedging is needed or rather desirable has become an important dilemma of risk management over the last years. As experience has shown, there are cases in which hedging is desirable, and cases in which is needed to cover certain risk exposures that a business cannot afford to ignore. At the same time, there are always some parties involved that should always gain from hedging. These parties are usually the intermediaries, such as banks. A bank that sells hedging instruments to its clients should always gain. However, banks that sell hedging should also hedge for themselves to offset their clients hedging positions. In practice, neither intermediaries, dealers and traders of derivative instruments, increase their value to shareholders through hedging. As both theory and practice suggest, derivatives trading for hedging purposed reduces risks, but risk reducing also leads to lower expected returns. In this view, value to shareholders could also be reduced by not allowing them to take higher risks for higher possible returns. To answer to our dilemma of whether hedging is needed or desired, we should consider risk management strategies on a case by case basis. Studies suggest that even if there are companies that more likely would be better off through hedging, the decision to hedge stands fully in their risk management hands.

The case study at the end underline the fact that in derivatives market, as in any other market, relative comparative advantages of two players give scope to trade if there is an incentive to gain from exchanging their benefits and also for arbitrage. A plain vanilla interest rate swap agreement has been chosen to demonstrate why and how two companies that have different relative advantages in raising debt can be better off by trading their interest rate advantages.

To summarize, hedging opportunities are increasing with the need and desirability to cover risk exposure. Hedging strategies differ with the type of business, risk aversion and sophistication techniques of risk management. Among all derivatives types in use for hedging purposes, swaps have become the most intensely exploited as the number of contracts, parties involved and volumes traded over the last years suggest.

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