CHAPTER 2

Financial Risk Management Tools and Tactics

Responses to Risk

Before beginning a discussion of the various tools and tactics used to manage financial risks, it is instructive to review the range of possible responses to financial risks. It is appropriate to realize that there is a range of responses to risk: eliminate, avoid, mitigate, ignore, embellish, and embrace.¹ These responses range from weak (mitigate, embellish) to neutral (ignore), to strong (eliminate, embrace), and also reflect the philosophy that risk can be positive as well as negative. Just as the responses to risk have a range, so too do the financial risk management tools. Furthermore, just as it is important in any type of craftsmanship to choose the right tool for the task, so it is in financial risk management.

Part of choosing the tool for risk management depends on whether the risk is predominately a negative risk, or predominantly a positive risk. Not always, but generally in financial risk management, a risk that is a negative risk for one organization is a positive risk for a different organization. A second component is understanding the side effects, or the unintended consequences of a risk tool. An old saying about financial risk management is that the “only perfect hedge is in a Japanese Garden.” Virtually all risk tools either have an explicit cost or some unintended consequence that renders the risk tool as less than perfect. That is simply the nature of risk management. That is not to say that one should not use risk management tools, but one does need to know the respective advantages and drawbacks of the various tools available to the risk manager.

Operational Financial Risk Management Strategies

There are several operational strategies for managing financial risk. For instance, operations can be designed to offset currency risks; financing can be arranged to minimize interest rate risk; sales contracts can be set to reduce commodity price risk. The way an organization chooses to implement its operations can provide a wide variety of risk benefits.

The design of both the revenue and the cost structures of the firm is the place to begin when considering operations as part of the risk plan. Different operational implementations can be used to either increase or decrease financial risks. Therefore, it is only prudent to consider alternative operational strategies as part of the overall risk management plan.

For one example, strategic placement of manufacturing plants is one basic strategy to reduce currency risk. With manufacturing and costs in the same currency as sales creates a natural offset where the currency exposures are set at a minimum. This is a very blunt tactic if used solely for risk management, but also one that has a host of other advantages (closer to market, potentially easier logistics, political protection against trade barriers) and disadvantages including significant direct and indirect costs (increased amount of assets tied up in plant and equipment, increased managerial supervision, lessening of economies of scale). Not only is it a blunt instrument, but it is also one that generally cannot be quickly altered or changed if the strategy of the company changes. Although a powerful tool, it is obviously one method for financial risk management that needs to be carefully considered and likely one that would not be chosen solely for reasons of financial risk management.

A simpler and more flexible way to accomplish much of the same financial risk mitigation as opening a foreign plant is to source financing in the same currency as sales will be. A company can finance in one currency and then convert the currency to the currency of the home country. This creates a revenue stream in a foreign currency (the foreign currency where the sales are being made), as well as an offsetting liability in that same currency (due to the sourcing of financing in the foreign currency). If the foreign currency depreciates, then net revenues calculated in the home currency will likewise decrease. However, the depreciation of the foreign currency also implies that the interest payments, and repayment of the loan in the foreign currency, will also decrease in value, relative to value in the home currency. This creates a natural offset. The offset will not be perfect as the sales revenue will likely not be equal to the value of the loan payments, but it is a good base from which to start a hedging program. This strategy can also be done synthetically using currency swaps and this will be discussed in Chapter 6.

Another similar strategy is to outsource the form of manufacturing that is causing the financial risk, whether it is currency risk or commodity risk. By outsourcing production which has, for instance, commodity price risk, under long-term fixed price contracts, a company effectively is shifting the price risk to the supplier. While doing so reduces the commodity price risk, it also reduces flexibility in manufacturing capability.

Similarly, a company can outsource its price risk for commodity inputs by setting up agreements with third-party sources for supply of commodity inputs at prearranged fixed prices. For instance, a Canadian company that uses oil as an input to its manufacturing could enter into a long-term fixed price deal with a fuel supplier to purchase oil at a fixed Canadian dollar price over a 5-year period. Such a contract would both fix (and thus hedge) the price of oil, as well as fix (and thus hedge) the exchange rate risk between the Canadian dollar and the U.S. dollar as oil is sold denominated in U.S. dollars. Again, this strategy involves shifting the price risk onto the suppliers, who likely will charge more for providing this implicit service, but even given a different cost structure it may be beneficial to do so on the basis of the risk management benefits.

Operations integrated with risk management can also be used for marketing advantage. For instance, a company could provide the option to its global clients to choose the currency in which they wish to pay. In essence, by offering fixed prices, in a variety of currencies, the company is giving a free currency option to its customers. Some clients will take advantage of this by timing their purchase to advantageous changes in exchange rates. Other clients will be thankful that they do not have to worry about the currency risk. Either way, the company can use this simple tactic to increase sales. Of course, this increases the currency risk for the company, but this currency risk can be offset using other financial risk management techniques. If the company is comfortable managing currency risk, the costs of doing so should be more than offset by the advantage given to the clients.

Effectively automobile companies do something similar when offering long-term leasing and borrowing rates at attractive fixed rates to its potential customers. The auto manufacturers, all of whom have advanced financial risk management capabilities, essentially manage the interest rate risk so clients can put their focus on buying new cars, rather than on what the fluctuation of car payments due to changing interest rates might be in the future.

Several different oil companies employ this strategy for heating fuel in Northern climates. Fluctuating fuel costs can be a major source of worry for home consumers of heating oil. Furthermore, the cost for fuel oil tends to be correlated with colder temperatures, so an especially cold winter could do serious harm to a family’s household budget; the colder it is, the more fuel oil they will require, and the higher the fuel price will tend to be. To counteract this and gain a marketing advantage, fuel companies will essentially offer a fuel price cap. For agreeing to pay a few pennies more per gallon of fuel oil, the fuel company will “cap,” or provide a maximum price for which fuel prices will rise over the winter months. In essence, the fuel company is offering its customers the choice to purchase a call option on fuel prices. The fuel company manages its increased price exposure to its own fuel costs, but provides peace of mind to its customers and has a significant marketing story to tell in its advertising.

When one thinks of managing financial risks, one generally does not think of managing them through strategic use of operational activities. However, operations can provide a very effective long-term baseline for managing a variety of financial risks. Furthermore, operational activities can be used to increase or decrease risk levels. Therefore, prudent risk managers will consider operations a key tool in their risk management toolbox.

Financial Tools

Introduction to Derivatives

When most people think of financial risk management, they think of using financial derivatives. Financial derivatives are a very efficient risk management tool. However, as with most tools, they can produce unintended consequences if used improperly, or without a full understanding of what they can and cannot accomplish.

A derivative in general is nothing but a contract that is entered into today that has a value that is based on the value of something in the future. For example, a currency option depends on the future exchange rate between two currencies, or a forward rate agreement depends on the realized interest rate at some specific point in the future. Derivative contracts are available on a wide variety of financial assets, such as interest rates, exchange rates, commodity prices, financial assets, and even the weather!

We can break financial derivatives into two basic types: forward type derivatives and option type derivatives.

A forward is a contract where the two counterparties agree today on a mutually binding price at which they will transact on a future date for a given quantity of an underlying asset. The buyer of the forward contract agrees to buy at the prespecified price, while the buyer agrees to sell at the prespecified price. There is no upfront cost or premium to enter into a forward agreement since the “forward price” is set so that it is a fair trade to both of the counterparties.

For instance, a company that uses oil in their manufacturing process may enter into a forward contract to purchase 1,000 barrels of oil in 6 months’ time at a price of $50 per barrel. If the price of oil rises above $50, they still pay $50 per barrel, and likewise if the price of oil is less than $50 in 6 months’ time, they still pay $50. In essence, the company has “fixed” their purchase of oil prices at $50 per barrel for the amount of 1,000 barrels.

An option contract is similar except that the buyer of the option contract has the right but not the obligation to transact at a given price in the future for a given amount of the underlying asset. The seller of the option contract has to transact whenever the buyer of the option “exercises” their option to transact. A call option gives the buyer the right (but not the obligation) to buy at a preset price called the strike price, while a put option gives the buyer the right (but not the obligation) to sell at a preset strike price. To have the flexibility to have the right but not the obligation to transact means that the buyer of an option pays an upfront premium to the seller of an option. Option contracts have more flexibility in design than forwards, as the preagreed-upon price to transact in the future can be set at different levels for which the size of the upfront premium can be adjusted to account for the different expected values to the two counterparties to the trade. In a forward contract, which does not involve an upfront payment, the forward price of the transaction needs to be set at inception at a level that is “fair” to both counterparties. Thus, there is one price at which a forward contract can be set, but there can be a wide range at which the “strike price” for an option can be set, as different strike prices will imply different option premiums.

For example, our manufacturing company instead of entering into a forward contract as a method to hedge their oil purchase may decide instead to pay $4 per barrel for a call option which gives them the option to buy 1,000 barrels of oil in 6 months at a strike price of $50 per barrel. If in 6 months’ time oil is selling at a price above $50 per barrel, then the company will exercise their option to buy the oil at $50. However, if the price of oil is trading at less than $50 at the time that the option matures, then they will choose not to exercise their option to buy at $50 from the counterparty, but instead will buy in the open market at the prevailing cheaper price. The option buyer thus is hedged against adverse price moves (oil prices going up in our example), but also gets to benefit from advantageous price moves (oil prices going down in our example).

In essence, our manufacturing company has “capped” the price they will have to pay for oil, while a company that has entered into a forward contract has “fixed” the price at which they will pay. Of course, the option has an associated upfront premium that offsets this advantage. This is a fundamental difference between forward style contracts and option contracts.

A put works the same way except that it provides a minimum price, or a “floor” on the value of an asset. For instance, a small gold producer may be concerned that gold prices will fall before they can mine their planned gold production in the next 3 months. To protect against falling gold prices, the miner could buy a put to sell 1,000 ounces of gold in 3 months’ time at a strike price of $1,200. Assume the premium for this is $10 per ounce, or $10,000 for all 1,000 ounces. If in 3 months gold is trading at a level above $1,200, the gold producer will not exercise their option to sell at a price of $1,200, but instead will sell at the prevailing higher market price. However, if at the time of maturity of the option the price of gold is below the strike price of $1,200, then the gold producer will exercise their put option and sell at the strike price of $1,200.

Options give the option buyer flexibility in that they allow the buyer to profit from advantageous price moves, while protecting against adverse price moves. Forward contracts “lock-in” the price. With a forward contract, the hedger is protected against adverse price moves, but does not have the opportunity to benefit from advantageous price changes.

Choosing between Doing Nothing, Hedging with a Forward Contract, and Hedging with an Option Contract

To illustrate the differences between not hedging and hedging with forward contracts and option contracts, it is helpful to consider a simple example. Assume that a purchasing manager needs to purchase a given commodity in 3 months’ time. The purchasing manager is concerned about rising prices for the commodity. The manager has three basic alternatives open to them; they could do nothing and buy at the prevailing price in 3 months’ time; they could enter into a forward contract to buy the commodity at a forward price of $100; or they could pay $10 and buy a call option to have the right but not the obligation to buy the commodity at a strike price of $100 in 3 months’ time.

Figure 2.1 below gives the level of “satisfaction” that the purchasing manager has with their strategy, given a reference point of $100.² The first column of the table shows possible prices for the underlying commodity in 3 months’ time. The second column shows the value of the “do nothing” strategy, while the third and fourth columns show the relative value of the buy forward strategy and the buy call option strategy, respectively.

Figure 2.1 Relative value of different hedging strategies

To understand the chart, consider the first row, which is the situation when the commodity has a realized price of $75. If the comparison reference price is $100, the price that could be locked in with the forward contract, then the manager who decided to “do nothing” would be quite happy. They will be able to purchase the commodity for the now reduced price of $75, thus saving $25 by adopting their “do nothing” strategy. The purchaser of the forward contract will be in a different situation. While they get to buy the commodity at the fixed price of $100 (by the terms of the forward contract, they have to buy at $100), they will realize that they are at a $25 disadvantage to the current market price of $75. Thus, the purchaser of the forward contract will have a $25 opportunity loss. The purchaser of the call option now has an option that is worthless. They will not exercise their option to buy at $100, but instead will buy at the lower current market price of $75, saving $25 from the reference price of $100. However, they paid $10 for the unexercised option, and so their net relative value will be a positive $15.

The situation is somewhat reversed if the price of the commodity soars to $125 by the maturity date. In this case, the manager who chose to do nothing will buy at the higher current market price of $125 and have a $25 loss compared with the reference price of $100. The purchaser of the forward will be quite pleased as they get to purchase at the locked-in forward price of $100, and thus realize a $25 saving from the current market price. Likewise, the buyer of the call option will exercise their call option and purchase the commodity at the strike price of $100, and thus save $25. However, the buyer of the call option paid an upfront $10 premium and so their net savings is $15.

There are a couple of key facts to note about the chart. First, you should notice that the outcomes from the do-nothing strategy mirror the outcomes from the forward strategy. If it is equally likely that the price of the commodity could go up or go down, then the expected relative value from the do-nothing strategy is the exact same as the expected relative value from the forward strategy. If the price goes down the do-nothing strategy outperforms, while if the price goes up, the forward strategy performs best. The second thing to notice is that the option strategy is always the second best strategy, and furthermore it is second best by the amount of the premium paid. For instance, if prices go down, the do-nothing strategy is best, the option strategy is second best, and the forward strategy is worst. Conversely, if prices rise, then the forward strategy is best, the option strategy is second best, while the do-nothing strategy is worst. Fundamentally, there is no strategy that performs “best” in all situations.

Hedging with forwards allows for price certainty, which in turn makes planning more straightforward. By hedging with forwards, a firm will be hedged against adverse price moves, but by locking in the cost, they will not be able to take advantage of advantageous price moves. The option strategy allows one to hedge against adverse price moves, yet still benefit from advantageous price moves. However, there is a cost for this flexibility, namely the option premium.

Case Study

Southwest Airlines

To illustrate a real-life scenario of contrasting the do-nothing strategy versus using forwards, it is useful to consider the case of Southwest Airlines and its hedging of jet fuel.

According to the IATA, the airline industry will spend US$130 billion on fuel in 2017, accounting for 17 percent of all operating expenses. To put this into perspective, total industry profits are expected to be $34.5 billion. Assuming increases in fuel costs cannot be passed on to customers, but are absorbed by the airlines, it would only take slightly more than a 25 percent increase in fuel costs to wipe out the profits of the entire industry! Given how volatile energy prices are, this seems to be a very realistic possibility. There are several financial products that can be used to hedge exposure to jet fuel, including crude oil futures that are very liquid and highly correlated to jet fuel prices, so hedging products are readily available for airlines. The question of whether or not to hedge is strategic, and several external dimensions must be considered. Can fuel cost increases be passed on to customers? We have seen many airlines implement fuel surcharges that help cover higher fuel costs, but there may be limits to how much customers are willing to absorb. Importantly, the behavior of competitors must be considered. If you choose to hedge and your competitor does not, then if fuel prices rise you are in a great position—your competitor will have increased costs that they will have to pass on to customers making their airfares more expensive or they will end up with lower profits if they don’t raise prices.

Many airlines decide not to hedge, including some that have abandoned hedging programs when things seemed to be going against them, but Southwest Airlines has been a strong proponent of hedging through oil’s ups and downs. In 2008, as oil prices rose to record highs, Southwest had praise heaped on its hedging program. Wired magazine published an article titled Southwest Airlines’ Seven Secrets for Success. One of those secrets was, of course, “aggressive fuel hedging.” Wired stated:

Rampaging fuel prices now represent around 40 percent of an airline’s costs, but, as usual, Southwest Airlines has been ahead of the curve. Since 1999, the airline’s aggressive fuel-hedging program has saved it an estimated $3.5 billion. In the first quarter, for example, it paid $1.98 a gallon for fuel, approximately a dollar less than its network competitors. And Southwest’s future position is admirable: It is 70 percent hedged at $51 a barrel through the end of the year and 55 percent hedged at the same price next year.³

The admirable future position didn’t work out exactly as planned, as only 3 months later Southwest reported its first quarterly loss in 17 years thanks to a $247 million charge related to the declining value of its hedging contracts. As the New York Times reported, “Southwest Airlines has long been the envy of the industry for its foresight in arranging contracts to lock in jet fuel prices. But its strategy may have backfired now that oil prices have dropped.”⁴ Those conflicting views of hedging are not uncommon in the media and general public—when hedges are in the money, the hedger is deemed a genius and when out of the money, the hedger is thought a fool. Of course, the truth is that if the objective of a hedging program is to mitigate exposure to market prices, a mix of gains and losses are to be expected over time as prices rise and fall. The success of a hedging program should not be measured only in hedging gains and losses, but in how much volatility has been removed from the underlying exposure.

This example illustrates the importance of understanding the competitive landscape, and clearly articulating the objectives and risks of a hedging program to all relevant stakeholders including shareholders, investment analysts, and ratings agencies.

Physical versus Cash-Settlement

Derivatives can be cash settled or physically settled. In a physically settled transaction, the actual underlying commodity is exchanged for the full dollar value specified in the contract. For example, assume a forward contract on oil with a notional amount of 5,000 barrels and a forward price of $52 per barrel. At the maturity of the contract, the forward buyer would pay $52 multiplied by 5,000 barrels and in return receive 5,000 barrels of oil. This transaction has a lot of operational components associated with it. Firstly, there is a large transfer of monies. Secondly, there is a transfer of 5,000 barrels of oil. Particularly for the financial intermediaries that frequently make a market in these transactions, these are cumbersome operational details to manage. Thus most (not all) derivative transactions are cash settled.

In a cash-settled transaction, only the cash value of the economic transaction is exchanged at maturity. Continuing with our forward example, assume at maturity that the market price of oil was $61 per barrel. In this case, the seller of the forward would deliver the difference between the market price and the contract price or $61 minus $52, or $9 per barrel to the forward buyer. Thus, the seller of the forward would pay the forward buyer $9 multiplied by 5,000 barrels, or a total of $45,000. Conversely, if the market price of oil is below the forward price, for example $48 per barrel, then the forward buyer would pay the forward seller the difference or, in this example, $20,000 ($52 minus $48 multiplied by 5,000 barrels). Note that in both cases, if the forward buyer purchases oil at the current market price, then their all-in cost including the forward payments will work out to be as if they purchased the oil for the contracted price of $52 per barrel.

Cash-settled transactions are much easier to deal with, and provide both the buyer and seller of the derivative more flexibility and thus they are more common.

Exchange Traded versus Over-the-Counter Derivatives

Forwards and options can be bought or sold directly between two counterparties, or they can be bought and sold on an exchange. Although the economics of the two methods are virtually identical in concept, there are advantages and disadvantages to each of the approaches. The mechanics also differ in two significant ways. Forward contracts that are traded on an exchange are called futures contracts, in part to distinguish them from forwards based on their operational characteristics. Economically, forwards and futures are very similar and conceptually behave in virtually identical fashion when they are used for risk management.

When trading derivatives on an exchange, the contracts are standardized. That is, the time to maturity, the notional size, the location of delivery (if it is to be physically settled), and the actual specific commodity being traded (for instance, 3-month interest rates, versus 2-month interest rates, or corn yellow number 2, versus corn yellow number 3) are all highly specified and standardized. This standardization facilitates trading, and creates more liquidity than would otherwise be available, but it makes designing a perfect hedge even more difficult than usual. It is highly unlikely that the exchange-set maturity dates, the exchange-set notional amounts, and the exchange-set specifications for the actual commodity will be exactly what are desired by a company that wishes to hedge an exposure. Exchanges set the terms and standardization of their contracts as a compromise between the needs of both speculators as well as hedgers. Designing contracts to attract speculators helps improve pricing, and it increases liquidity and ease of trading, but it does so at some compromise to the flexibility desired by the hedgers.

In an over-the-counter trade, which is a negotiated trade between two counterparties of which one is generally a financial institution, the terms of the contract can be set to whatever the two counterparties agree upon. There are few limits as to how the contract can be designed. The implicit cost for this is that the more bespoke the contract is, the less liquidity, or the fewer counterparties there will be to trade out of the contract if the risk management needs of one of the counterparties change. This lack of liquidity may also have explicit costs, as the more bespoke the contract, the more likely there will be hidden embedded fees. The advantage for the hedger is that they get a contract that exactly meets their hedging specifications.

A second difference in the mechanics is the aspect of counterparty risk. When entering into an over-the-counter derivative contract, there is the risk that your counterparty may not be able (or willing) to fulfill their contractual obligations. This is called counterparty risk. For over-the-counter trades, counterparty risk is managed by limiting the amount of counterparty exposure to any given counterparty, and by ensuring that you only trade with highly rated counterparties. This is why the counterparty in an over-the-counter trade is almost always a highly rated financial institution.

When you trade on an exchange, in effect you are trading with the exchange itself. Since all the contracts are standardized, it also implies that they are fungible. Thus, the exchange in effect creates a pool of buyers and sellers and internally matches them up through the actions of market makers. To ensure fulfillment of contracts, the exchange requires all traders (and market makers) to post margin, except in the case of buying an option, in which case the premium is paid upfront so there is no counterparty risk in respect to the option buyer (but there is counterparty risk to the option seller). This margin is adjusted on a daily basis depending on whether the contract increased or decreased in value for each counterparty. If the value of the contract increased, then that counterparty’s margin account is credited, while conversely the margin account is debited for the counterparty whose side of the contract decreased in value that day. If a margin account falls below some preset threshold, then that counterparty will be required to add more cash (or equivalents) to their margin account, in what is labeled a margin call. If the counterparty is unwilling or unable to meet the demands in a timely fashion, then their account is closed out at a loss and penalties may be incurred.

The significance of margin calls is that they imply that a firm using exchange traded contracts may have to make interim cash payments in order to satisfy a margin call. In Chapter 7, a case study of the German conglomerate Metallgesellschaft will be discussed. Metallgesellschaft was using short-term futures contracts to hedge a very large, and a very long-term oil price risk. Due to fluctuations in oil prices, the company faced a very large series of margin calls amounting to over $1.3 billion. Many experts believe that the company would have more than recouped these cash flows at the expiration of their long-term oil deals, but the interim cash flows required by the exchanges forced it to close out its risk management strategy at a huge loss. The case of Metallgesellschaft is a cautionary tale about margin calls, albeit a very extreme case.

A major advantage of exchange traded derivatives is the price transparency. The exchanges publish continuously updated prices, so when a trade is made, a company has a relatively high degree of confidence that the price is a fair one.⁵ As risk management needs are likely to change, it means that companies will need to change their hedges and thus enter into new contracts and perhaps settle early, or close out, some existing contracts. In such cases, having price transparency, along with the extra liquidity of an exchange traded derivative can be a significant advantage.

Closing or Canceling a Trade

In reality, almost all exchange traded derivative contracts are closed, or canceled, before expiration. This is especially true for commodity contracts that are physically settled. This is in large part due to the standardization of exchange traded contracts not matching the exact needs of the hedger. The contract in essence gets settled for its fair market value, and then a new series of contracts may be entered into. As most exchange traded derivatives have relatively short terms to maturity, it is often necessary for companies to enter into a series of contracts one after another. This is another reason why such a large proportion of exchange traded contracts are closed out early. Over-the-counter trades may also be closed out early if the risk management needs of the company have changed and contracts with different terms are now needed.

To close out an exchange traded contract, it is normal practice to enter into an equivalent contract, but in the opposite direction. For example, if one bought a futures contract for expiry in May, then one would close out that trade by selling an equivalent number of the same contract that also expire in May. The exchange then internally cancels the buy side and the sell side of the transaction.

Since the price of the underlying of the derivative contract would have likely changed in price since the inception of the original trade, this also implies that the value of the contract would have changed. Thus, the net proceeds received from closing out a derivatives contract early is the change in value of the contract—which could of course be positive or negative. The value of a contract at any time is called the mark-to-market value. That is, it is the price of the contract based on the market values of the pricing variables that go into pricing the contract.

The pricing of contracts is beyond the scope of this book. There are several websites and data providers that provide pricing calculators, and of course the price of a contract is always visible for exchange traded derivatives.⁶

For over-the-counter trades, the price to close out the transaction will be negotiated between the counterparties. The counterparties will agree to cancel the trade for a negotiated fair value. This is where the hedger may be at the mercy of the counterparty if they do not have access to pricing software or pricing screens. In such cases, it is always best to shop various dealers to get their respective prices on the transaction. It may be better value to do the offsetting trade with another dealer. This of course would not cancel the trade, and the hedger would in fact have two outstanding trades, but economically they would cancel each other out. The only residual exposure would be the counterparty risk to not just one, but now two counterparties.

Swaps

Swaps are in essence a series of forward contracts that settle on a set of periodic dates. In a typical swap, one counterparty agrees to make a payment based on a notional amount and the market price of an index or a commodity, and the other counterparty agrees to make a fixed payment based on the same notional amount.

One of the most common examples of a swap is an interest rate swap. Figure 2.2 illustrates this.

Figure 2.2 Illustration of an interest rate swap

Dashed line shows floating rate payments, while solid line illustrates fixed rate payments.

In this example swap, the two counterparties have an agreement where every 6 months for a period of 5 years, they will exchange payments. The swap will be based on a notional amount—for instance $10 million. The fixed rate payer will then pay the notional amount, multiplied by the fixed swap rate, multiplied by the day count ratio since the last payment. If the swap payments are made every 6 months, then the day count ratio would be one-half, since it was half a year since the previous payment.⁷ The floating rate payer also makes a payment which in this example is based on the LIBOR, the London Interbank Offer Rate, which is a floating rate index that is frequently used as the basis for floating rate loans. The payment by the floating rate payer will be the notional amount, multiplied by the LIBOR setting for the period in question, and again multiplied by the day count ratio. Generally, only the net payment is made. If the LIBOR for the period is higher than the fixed rate, then the floating rate payer will make a net payment of the difference to the fixed rate payer. Conversely, if the fixed rate is greater than the LIBOR for the period, then the fixed rate payer will make a net payment to the floating rate payer. It is effectively the same as if the two counterparties had entered into 10 separate forward contracts, based on the LIBOR interest rate and with each forward price set at the fixed rate agreed to in the swap.

Swaps can be based on interest rates, commodity prices, exchange rates, energy prices, and even equity prices. Figure 2.3 illustrates an example of a commodity swap based on oil prices.

Figure 2.3 Illustration of a commodity swap

Dashed line shows floating rate payments and solid line shows fixed payments.

In Figure 2.3, assume that it is a 3-year, quarterly swap, based on a notional amount of 5,000 barrels of oil. Also assume that the fixed oil price (the swap rate) is $52 per barrel. Thus, in this example, every 3 months, the fixed rate payer will make a payment of $52 multiplied by 5,000 barrels to the floating rate payer, and in return the floating rate payer will make a payment of 5,000 barrels multiplied by what the market price of oil was for that period. Again, the payments are generally netted, so if the market price is above $52, then the floating rate payer will make a net payment, and conversely if the market price for the period is below $52, then the fixed rate payer will make a net payment. In effect, this swap is equivalent to the fixed rate payer entering into 12 different forward contracts spread out with maturity dates over the next 3 years, to buy 500 barrels of oil at a forward price of $52 per barrel.

Swaps are a very convenient tool for hedging a series of financial risk exposures such as the interest payments on a loan, a regular purchase of a commodity, regular transfers of foreign currency, and a variety of other regularly occurring transactions. Given their flexibility, swaps are the workhorse of financial risk management.

Concluding Thoughts

To briefly summarize, there are two main classes of financial risk management strategies; operational strategies and the use of financial derivatives. Operational strategies should form the backbone of long-term and ongoing financial risk exposures. However, operational strategies tend to create long-term commitments, such as building a foreign plant, and tend to be blunt instruments if used solely for financial risk management purposes. Thus, the use of derivatives acts as a nice complement to operational strategies, as derivatives can be used as a flexible tool to fine-tune the risk management strategy to account for risks that are more transactional in nature.

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¹This list is from R. Nason and L. Fleming. 2018. Essentials of Enterprise Risk Management (Business Experts Press), New York.

²Most risk managers will compare their hedge strategy to the forward price as that is the fair price at which they could have “fixed” their price if they so desired.

³J. Brancatelli. 2008. “Southwest Airlines’ Seven Secrets for Success.” https://www.wired.com/2008/07/southwest-airlines-seven-secrets-for-success

⁴M. Maynard. 2008. “Southwest Has First Loss in 17 Years,” The New York Times. http://www.nytimes.com/2008/10/17/business/17air.html

⁵Note that if a price on an exchange is out of line, or unfair, market speculators and arbitragers will immediately step in and take advantage of the mispricing until the price moves back to a fair level.

⁶Readers interested in the pricing of derivatives can consult a textbook such as J. HulJ. 2017. Options, Futures and Other Derivatives (10th ed., Boston, MA: Pearson).

⁷There are a variety of different ways of calculating the day count ratio. The specifics of the day count ratio are specified in the swap contract. For an interest rate swap, the day count ratio is generally set up so it matches the day count ratio on a loan that it is hedging.