This write-up is a continuation of an earlier publication on how risk managers could employ derivatives such as options, swaps, futures, and forwards to effectively mitigate risk in their respective organisations. Discussions in the previous publication ended on some examples of swap contracts. The current write-up continues with explanations on swap contracts and extends to other derivatives and risk-mitigating measures such as forward and futures contracts.
Credit Spread Swap
In a credit spread swap, the emphasis is on the credit spread, which measures the difference between a risky bond’s yield and the yield of a Treasury bond which compares to the risky bond. Here, quality of the risky bond and Treasury bond may differ; the Treasury bond may have a strong quality than the risky bond. For instance, a 15-year corporate bond may be issued at 12% and a 15-year Treasury bond issued at 10%. Due to the risky nature of the corporate bond, one observes it has a higher yield than the Treasury bond. The former is said to offer a 200-basis-point spread over the latter. Some analysts refer to credit spread swap as the relative performance total return swap. A credit spread swap involves three parties: Party A; Party B; and Party C, commonly referred to as a Third Party. Under this contract, Party A agrees to make fixed payments to Party B against a floating spread with a value equivalent to the actual credit spread underlying the contract, and held by a Third Party. Stated differently, it is where Party A agrees to make a payment based on the yield-to-maturity of a predetermined debt of Party B. In return, Party B agrees to pay Party A, based on an equivalent yield used as a benchmark in the agreement. In this case, the benchmark could be the yield of a Government’s (Third Party’s) Treasury bond. On one hand, a lower basis-point is indicative of corporate and other private borrowers’ creditworthiness; it symbolises their ability to repay their debts within time or at the due date. On the other hand, a higher basis-point raises concern about corporate and other private borrowers’ ability to service or honour their debt obligations as they become due.
There is a thin line, if any, between fixed-floating interest rate swap and commodity swap. A contractual agreement under the commodity swap is underpinned by a spot, market or floating price which is often determined based on an underlying commodity. Price of the underlying commodity serves as the basis for exchange of cash flows between the two parties involved in the contract over a considerable or specified period of time. Parties involved in the contract use commodity swap to hedge against the price of a trading commodity of interest.
Legs of a Commodity Swap
Generally, a commodity swap has two components namely, fixed-leg component and floating-leg component. A fixed-leg component is often specified in the contractual agreement; and held by the producer who assents to making floating rate payments, determined on the basis of the spot or market price of the underlying commodity. The floating-leg component of the commodity swap contract is tied to a commodity index agreed upon by parties to the contract or the market price of the underlying commodity; and often held by the consumer of the commodity, or the party willing to pay a fixed price for the commodity. Although different commodities such as livestock, grains, precious metals, and natural gas, to name a few, could be used in this contract, it is often entered into, with oil as the underlying commodity. The magnitude and size of commodity swap contracts limit such transactions to corporate bodies, notably large financial institutions, and not individual investors.
A commodity swap allows consumers to access goods, products or commodities in the market at a fairly stable price over a given period of time. Similarly, it provides producers the necessary hedge against market price fluctuations throughout the duration of the contract. Physical delivery of commodities is usually outlined in a commodity swap contract. However, it is often characterised by cash settlements; parties involved in a commodity swap normally exchange cash, not a commodity or commodities. To illustrate, suppose RASEAN Corporation needs to purchase 400,000 barrels of oil each year to meet its production targets for the next two (2) years. The determined forward prices for oil deliveries in years one (1) and year two (2) are $45 per barrel and $48 per barrel respectively. The contract includes one-year and two-year zero-coupon bond yields of 4% and 4.5%. RASEAN Corporation has two options. That is, decide to make an upfront payment for the entire two years or make annual payments contingent on oil delivery by the supplier or seller.
Should RASEAN Corporation decide to make one-time payment for the two-year contract, the cost of oil per barrel would be $87.2242 [($45 ÷ (1.04)) + ($48 ÷ (1.045)²) = $43.2692 + $43.9550 = $87.2242]. To receive 400,000 barrels of oil each year for the next two years, RASEAN Corporation would have to pay $34,889,680 today ($87.2242 x 400,000 barrels = $34,889,680).
Counterparts Risk under Commodity Swap
In some cases, the supplier or seller may not be able to deliver the oil as agreed upon. This is often called a counterparts risk. In such a situation, RASEAN Corporation, the buyer or consumer, may agree to make two payments: a payment for each year the 400,000 barrels of oil are delivered. For annual payments, RASEAN Corporation would pay about $46.4910 per barrel [(X ÷ (1+ 0.04)) + (X ÷ (1 + 0.045)²) = $87.2242 = (X ÷ (1.04) + (X ÷ (1.0920) = $87.2242 = (2X = $87.2242 x 2.1320) = ((2X÷2) = $185.9642 ÷ 2) = (X = 92.9821 ÷ 2) = X = $46.4911]. The total cost of oil delivered yearly to RASEAN Corporation would be $18,596,440 ($46.4911 x 400,000 barrels). The total cost of oil delivered in two years when avoiding counterparts risk would be $37,192,800 ($18,596,400 x 2 = $37,192,880). Settling for option two would result in excess payments of $2,303,200 ($37,192,800 – $34,889,680), representing 6.60% [($37,192,800 – $34,889,680) ÷ $34,889,680) x 100% = ($2,303,200 ÷ $34,889,680) x 100% = 6.60%] increase. If RASEAN Corporation is certain of the oil delivery by the supplier, it would be cost-effective for it to adapt the first payment option, that is, the one-time payment for the two-year contract.
Financial derivative contracts such as an equity swap enhance organisations’ chances of hedging specific assets or positions in their asset portfolios. An equity swap makes it possible for parties to a contract to exchange future cash flows at a specified date. Parties to an equity swap have the opportunity to diversify their incomes throughout the contract and still hold on to their original assets. Based on the terms of the equity swap, the parties may exchange two sets of nominally equal cash flows at the future date. The exchange may involve trading of fixed-income cash stream based on a benchmark rate, for an equity-based cash stream from sources, including stock asset.
Legs of an Equity Swap
The performance of an equity security or index plays a crucial role in the execution of an equity swap. Cash flow exchanges in an equity swap are linked to floating rate and fixed rate securities. The floating rate and fixed rate are commonly referred to as the legs of an equity swap. In addition to hedging specific assets, an equity swap allows parties to enjoy tax benefits and diversification; it allows parties to share in equity security returns without necessarily owning shares.
Some major players in the equity swap market include capital lending institutions, auto financiers, and investment banks, among others. Parties to an equity swap may use the London Interbank Offered Rate (LIBOR) as a benchmark for the stream of fixed-income. The floating rate may be tied to the performance of an equity security or index over a given time period.
One of the derivative instruments used in hedging against strategic exposure is forward contracts. Forward contracts are the oldest, and perhaps the most straightforward securities. A forward contract owner is obligated, by the agreement, to buy an asset on an agreed-upon date at a predetermined price called the strike price. The contract obligates the other party to sell the asset on the specified date. A typical example of forward contracts is the firm’s delivery of products to its customers. The contract owner derives a profit if at the expiration date the market price exceeds the strike price. However, the owner incurs a loss when the market price, at the expiration date, is less than the strike price. The owner’s profit or loss is equal to the difference between the market price and the strike price at maturity. The parties’ strict adherence to the contractual agreement hinges on their moral and financial strength. In the absence of the foregoing qualities, there could be a contract default, especially when there is a significant change in the price of the commodity on the maturity date, which could result in a tremendous loss to a party.
There is a similarity between a forward contract and a futures contract. Just like a forward contract, a futures contract owner is obligated to buy a given commodity at a strike price on a predetermined date. In spite of the similarities, they also have differences. First, futures contracts are different because their value is determined on a daily basis, they are marked-to-market and cash settlement is made on a daily basis, not on the contract maturity date. This means at the end of the day, the futures contract is evaluated to identify any gains and losses thereof. If a loss is recorded, the amount is paid by the owner to offset the losses whereas daily gains are paid to the owner. Gains and losses in forward contracts are only paid on the expiration date. Futures contracts help to minimise the default risk associated with forward contracts.
Second, futures contracts are standardised securities that are traded on the various exchanges. However, forward contracts are not traded after signing; they involve a negotiation between two parties; and are often tailor-made to suit the parties to the contract.
Finally, unlike forward contracts in which the two parties converge to physically exchange the commodity, futures contracts do not emphasise on the physical exchange of the product. Rather, the parties make a settlement for any difference between the market price and the strike price on the maturity date. Like any other derivative, the underlying function of a futures contract is to prevent or minimise risks that the firm may face in its operations.
Eliminating Expensive Lower-Tail Results
As a paradigm shift from the normal approach to risk management, some finance experts have proposed the elimination of costly lower-tail outcomes by corporate executives. The purpose of this theory is to complement the efforts of managers aimed at reducing the expected costs of financial difficulties while attempting to preserve their organisations’ comparative advantage in risk-bearing. This theory suggests some firms should focus primarily on hedging only some of their risks; others should not hedge at all, while others should hedge all their risks. Extant research reveals risk management could be used as a medium of modifying the ownership and capital structures of a firm.
Through risk management, corporate executives are able to minimise financial burden, increase management’s equity, and the firm’s debt equity. It is often argued that, even though identified measures such as Value at Risk (VAR) and variance are useful risk management tools, they are not applicable to organisations such as non-financial institutions.
Risk management programmes of most firms are apparently designed to preserve upside potential while putting the necessary measures in place to prevent lower-tail outcomes. It is worth noting the Value at Risk was first developed by J. P. Morgan Chase as a facilitating tool for financial institutions in monitoring the exposures emanating from their involvement in securities trading. However, today, organisations other than financial institutions also employ the VAR in analysing the risks of their instruments portfolio.
In spite of the merits associated with the VAR, it is believed managers cannot use it to eliminate lower-tail results to prevent financial distress; the information provided by the VAR is not relevant when corporate executives seek to determine whether the firm’s current value would fall below some crucial value over an extended time period. Most short-term risk management programmes focus on transaction exposures whereas most long-term risk management programmes are designed to hedge against economic or competitive exposures. The latter is consistent with a risk management programme which focuses on lower-tail results. This assertion is consistent with the LEAPS which have extended maturities of up to two-and-half years. LEAPS are listed on major exchanges, and are available on individual stocks and stock indices. Discussions in this section indicate the LEAPS would be more useful to companies than the conventional options with a maximum duration of six months.
Ebenezer M. Ashley (PhD)
The Author is a Senior Consultant at Ghana Investment Services Centre,
Founder of Eben Consultancy,
Fellow and Council Member of the Institute of Certified Economists of Ghana (ICEG)